August 4, 2023
Preface
The Fed's June shift in expectations for short-term interest rates seemed to catch markets leaning the wrong way to a degree. The June "pause" in lifting interest rates did come as expected, but was to be short-lived, given Fed members' projections of where they thought monetary policy would go for the rest of 2023. Instead of the June pause perhaps presaging a longer spell of unchanged policy rates, the Summary of Economic Projections clearly revealed that the pause would be only a one-off "skip", and suggested that it wouldn't be long before at least one rate hike -- and possibly more -- would be in the cards.
The one-meeting skip ended with the late-July FOMC meeting, where the federal funds and other policy interest rates were moved up by another 25 basis points to the highest level in about 22 years. The move was not accompanied by any sort of guarantee or even an inference that rate hikes were now complete, and the door remains open for another quarter-point lift at one of the remaining three Fed meetings this year, possibly as soon as September.
Investors spent the early part of the summer recalibrating their positions to account for the Fed's new policy message, pushing interest rates higher, This has been the case despite signs of cooling inflation and slightly loosening labor conditions, happenstances that would generally have been expected to produce the opposite effect. What matters now isn't whether or not the Fed does lift rates slightly again; rather, it's what the data reveals about trends for inflation and the labor market and how the Fed is thinking about its policy stance for the future that will drive mortgage rates this fall.
In some ways, the Fed is coming to a rather tricky place for policy and messaging, and what the data reveals over the next two months could complicate (or simplify) things.
Recap
Our most recent forecast was anything but our finest offering. As we developed it, fixed mortgage rates were fairly flat at in the middle of 2023 ranges, and looked as though they were going nowhere very fast, and we looked forward on the basis of that premise. When the minutes of the Fed's May 2-3 meeting were released on May 25 and suggested that there was a chance that any pause might be only temporary, the downward pressure on mortgage and other interest rates released. In the ensuing week, and certainly by the time the mid-June FOMC meeting arrived, it was clear we were caught leaning in the wrong direction, too.
Our late May forecast called for the average offered interest rate for a conforming 30-year FRM to hold a range between 6.20% and 6.65%, and rates at the time were roughly in the middle of those two bookends. However, with the shift in market sentiment keying off the Fed's new position, the market delivered average rates of 6.57% to 6.96% over the nine-week span. Our expectation for perhaps a 45 basis point gap was fair enough, but it was certainly not in the right position on the interest-rate scale.
The range we expected for hybrid 5/1 ARMs was also upended by the shift in Fed and market sentiment. While this was also a miss, it's also helpful to consider that 5/1 ARM info comes from Freddie's legacy PMMS survey, and that these are quotes for Treasury-based 5/1 ARMs for conforming loans. Neither Freddie nor Fannie buy TCM-based ARMs any longer; new 5-year conforming ARMs are tied to SOFR and have 6-month adjustment frequencies, and so the TCM-based product is no longer the common instrument in the conforming market.
In addition, most ARMs are made by depository institutions, who keep most ARMs for their own portfolios, and are written most frequently for jumbo loan amounts. All said, it's likely that the data being gathered from lenders who report to Freddie isn't all that deep or robust any longer, which in turn led to some sizable increases and decreases during the period. Regardless, the average rate of those who did report these ARMs ran a range of 6.12% to 6.60%, but since we expected a 5.60% to 6.20% pair of stops we missed the mark to the upside here, as well.
Forecast Discussion
Things will likely become a little trickier for the Fed over the next couple of months. There's a longer-than-usual gap between the July and September meetings (about 8 weeks instead of the usual 6) and so there is rather more data to consider before the next policy move comes. Among other data series, this includes two employment situation reports, two JOLTS reports, two CPI reports and two reports covering PCE prices, the Fed's preferred measures.
We already saw one of those PCE reports, for June: in it, inflation cooled again, with core PCE inflation decreasing to a 4.1% annual clip, its best showing since September 2021, While still about two times the Fed's desired level, it has shown considerable deceleration, as this same measure was running at a 5.2% annual rate as recently as last September. For those interested in the math, that's a 21% decline in core inflation in just the last 10 months, so core inflation is cooling at a fair clip.
Not really cooling at all is the overall economy; the first estimate of growth for the second quarter of 2023 pegged GDP growth at a 2.4% annual rate, up from 2% to start the year. While this it still a modest-to-moderate level of growth, and one close to the economy's potential, it's likely too strong to provide the kind of drag needed to ensure that inflation continues to move steadily in the right direction. There are expectations that slower growth may come later this year or perhaps early next, but forecasts for recession have been kicked down the road again, and even the Fed's own staff is no longer calling for any widespread economic contraction.
The labor market is perhaps a touch looser, with somewhat fewer job openings. June's rate of new hires was solid enough but still the slowest rate in about two and a half years, and revisions subtracted 110,000 positions from April and May. The unemployment rate remains near historic lows, but so do initial claims for unemployment benefits. Labor costs are down a little from recent highs, but wage growth as tracked by the Employment Cost Index are still running too warm at 4.6% for the second quarter of 2023, although this has settled back from 5.2% in the same quarter a year ago. The latest JOLTS survey, covering June, showed another small decline in job openings, but despite only a slight dip, if was enough to put open positions at more than a two-year low.
But even if they are cheered by what they see, the Fed is wary about revealing any kind of satisfaction with progress made to date. Financial market conditions have tightened a fair bit since the Fed began raising rates and reducing its balance sheet and they will likely need to remain durably tight for a while to get price pressures back to where they need to be.
Financial markets have gotten ahead of themselves on several occasions during this tightening cycle, and, for example, major stock indexes are up considerably since the lows of last fall, while concerns about the banking sector have faded. Data suggesting progress toward the Fed's goals should be enough to keep financial markets perking along, but any intimation of a "mission accomplished" or even a "we're close" message from the Fed risks sending stock markets off on more of a tear. This is just the kind of loosening financial conditions the central bank is hoping to avoid, at least for a while yet.
If the data over the next month or so is in line with the Fed's expectations, the chance of another rate hike will remain. In his comments after the July meeting -- where a quarter-point hike took place -- Fed Chair Powell noted that "...the intermeeting data came in broadly in line with expectations... and the June CPI report actually came in a bit better than expectations for a change," but the Fed still thought that another hike was warranted. But what if the data starts to come in rather more favorable -- that is, somewhat greater loosening in labor markets than has been the case, and more steady progress toward the Fed's inflation goal? Will investors believe the Fed if it continues to promote a "hawkish" message out of necessity, even if the data are broadly more favorable?
And, if it is, what become of that "hawkish" message if the next Summary of Economic Projections (released at the close of the September meeting) show that members have begun marking down policy expectations for next year? Even in June, as the members lifted their expectation for the federal funds rate to a median 5.6% by the end of this year, the consensus was that by the end of 2024, a full percentage point of rate cuts will already be in place. If the September SEP points to more than 100 basis points in cuts, markets may start to expect that the first reduction in rates is coming soon and perhaps as soon as just a couple of quarters away. That could spark a rally in markets and a loosening in monetary conditions that actually might make it harder for those rate-cut hopes to come true.
So, it's a little tricky for the Fed at the moment. It needs to get monetary policy where it wants it to be and keep it there, and not have the market subvert its intentions. In comments during his press conference, Mr. Powell said that "the Federal Funds Rate is at a restrictive level now..." and that the Fed intends to "certainly hold policy at restrictive levels for some time," but also that "policy has not been restrictive enough for long enough to have its full desired effects." At some point, perhaps soon, this outlook may become at odds with the SEP or other forecasts of lower rates coming sooner than later.
Forecast
With the prospect of another potential rate increase hanging over the markets for the remainder of the summer, it may be difficult for mortgage rates to decline very much from present levels, at least until the forward path becomes more clear. Unfortunately, the greatest clarity won't come until the end of the next Fed meeting, when the new Summary of Economic Projections comes.
Until then, investors will need to suss through the data just as the Fed will. Mr. Powell mentioned that the Fed will consider what to do based on "the totality of the data [...] but with a particular focus on making progress on inflation." This doesn't mean that investors or the Fed won't be concerned about too much firmness in labor markets or growth that is running warmer than expected, but if inflation -- especially core PCE inflation -- continues to step down over the next two months, this may be sufficient to keep the Fed at bay. If this sort of data environment develops, mortgage rates may have some space to decline, but that would likely be toward the end of the forecast period.
The reverse is also true. If inflation shows no signs of downward progress or worse, shows signs of firming up a bit over the next nine weeks, not only does September become a "live" meeting, but the chances of a SEP forecasting expectations of higher rates for longer becomes a real possibility, and mortgage rates may rise in turn.
All this in mind -- and also considering that the first full business week after Labor Day has often seen the start of new trends for interest rates for the fall -- the September 19-20 Fed meeting may provide a convenient trigger point for any change in direction for rates. Until then, we think that the average offered rate for a conforming 30-year fixed-rate mortgage as reported by Freddie Mac will run in a range between 6.70% and 7.08%; for hybrid 5/1 ARMs, a 6.38% to 6.83% pair of bookends for average offered rates seems most likely.
This forecast expires on September 28, 2023, a full week into fall and already three weeks into the NFL season. On a halftime break, drop back in and see if this forecast scored or whether we fumbled again.
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