Last year, we began to see widespread inflation, in everything from gas prices to our weekly grocery run. In fact, February’s Consumer Price Index reached 7.9% annually, which is the hottest reading since 1982, when it was at 8.4%.
Why is this significant?
Inflation is the archenemy of fixed investments like Mortgage Bonds because it erodes the buying power of a Bond's fixed rate of return. If inflation is rising, investors demand a higher interest rate to offset the faster pace of erosion of the buying power of their fixed payments they receive. This causes interest rates to rise.
The Fed has been under pressure since late last year to take action to address inflation. Note that the Fed has two levers they can pull for tightening the economy – hiking their benchmark Fed Funds Rate and reducing their balance sheet. The Fed Funds Rate is the interest rate for overnight borrowing for banks and it is not the same as mortgage rates.
Hiking the Fed Funds Rate will actually be a good thing for mortgage rates, as the Fed curbs inflation and preserves the fixed return a longer data Bond provides. However, reducing their balance sheet (which means allowing Bonds to fall off their balance sheet and no longer reinvesting in them each month) would cause more supply on the market that has to be absorbed. This can cause mortgage rates to move higher.
Investors were closely watching the Fed’s meeting on March 15-16 to see what the Fed would do – and what their forward guidance would suggest. Are they going to continue to hike the Fed Funds Rate at each of the next upcoming meetings? Will they allow their balance sheet to runoff at some point this year?
Here is a breakdown of what the Fed did, and what we might expect in the months ahead.
As expected, the Fed hiked the Fed Funds Rate by 25 basis points. Looking at their dot plot chart, the majority of Fed members are expecting seven additional hikes this year. There are six remaining Fed meetings this year, which implies that there would have to be a double or 50 basis point hike at one of the upcoming meetings.
In addition, the Fed increased their 2022 inflation expectations by 65% from 2.6% to 4.3%. They also revised GDP lower from 4% to 2.8%.
The big negative for Mortgage Bonds was the Fed’s comments on their $9 trillion balance sheet. The Fed said that they would start to reduce their balance sheet at “a coming meeting” and in the Q&A session on Wednesday after the meeting, Fed Chair Jerome Powell said they may finalize their plan at their next meeting in May.
The bottom line is that we will want to closely watch how the Fed tries to walk the tightrope of hiking and allowing a balance sheet runoff during 2022, as these actions will play a critical role in the direction of Mortgage Bonds and mortgage rates this year.