Is the Treasury Market Ready for the Fed?
Is the Treasury Market Ready for the Fed?
We opened our article last Friday with the thought that, with a light data calendar, a Fed having gone into its pre-meeting quiet period, and a dearth of new information the market would range-trade until the meeting. Well, we got that wrong. The market was in no mood to wait and spent most of this week bumping up yields in anticipation of more hawkish messaging from the Fed. The intermediate part of the Treasury yield curve moved to levels last seen prior to anybody knowing what Covid-19 was. To be fair, some of the heavy selling from late last week into early this week has abated, so Treasury investors appear comfortable with current yields.
We talk in more detail below what we think we’ll hear from the Fed on Wednesday, and what the market reaction will be, but given our recent track record don’t bet the house on it.
Where Are We in the Business Cycle?
As we speed towards the FOMC meeting next week, we are left to ponder how well the Treasury market is positioned for the decisions and information that will come out of the meeting. The consensus view seems to be the Fed will signal quarterly 25bps rate hikes beginning in March, a terminal rate of 1.75% when all is said and done, and balance sheet runoff beginning around mid-year. If that is what Powell communicates in the press conference, you can expect Treasuries to see higher prices and lower yields. If something is delivered outside of those parameters, say a signal that the initial hike may be 50bps, expect more selling on the front-end to adjust to a Fed definitely feeling behind the curve.
While the consensus outlook mentioned above, if met, will lead to the least volatility, there is plenty of uncertainty around each of those elements. Thus, investors will enter the announcement on edge, so expect some nervous trading leading into the meeting.
Speaking of the meeting, we’re reminded all of this is about the business cycle and what that means for rates and the economy in general. The above chart was a staple of our bond school presentations and it often reduced some of the noise in day-to-day events into a much more manageable playbook. We’ve tried to plot our best guess on where we are in the cycle, but this recovery is admittedly different due to pandemic programs and changes in market participant behavior. Generally speaking, however, we still believe we’ll follow this pattern, more or less.
As the table shows for the Fed, they have most definitely shifted their narrative with a tightening phase to follow. Yield curves have flattened but are still a long way from inverting, and the 10yr Treasury yield is definitely not trending lower. But are we close? This chart says yes, but will pandemic influences disrupt a playbook designed for a more plain vanilla environment? Stay tuned.
Mortgage Spreads Reach One-Year High as Treasury Volatility Roils Markets
For the past year, MBS investors have often had to hold their noses and buy pools with incredibly tight spreads to Treasuries. Whether it was the Fed driving spreads tight via their quantitative easing purchases, or just demand for any type of longer-duration yield and loan substitute from the bank investing crowd, yield spreads remained tight throughout the year.
As the graph below shows, FNMA 30yr MBS yield spreads to a 10yr/5yr Treasury blend got as tight as 60bps in May and just over 80bps earlier in March. The rest of 2021 saw those spread ranges tighten even more. Not an exciting landscape for MBS investors to be sure.
Enter 2022, and it’s been pretty much a one-way ticket to higher spreads as the Treasury sell-off and volatility filtered into the MBS universe. As shown, the most recent yield spread at 84bps is the highest over the last year. That being said, the spread did reach a wide of 90bps earlier in the session, before bargain hunters started to close the gap. The 6bps drop in a single day was the most in almost 11 months. Current coupon FNMA 30yr yields are around 2.50%, which is the highest since prior to the pandemic, and yield-starved investors have taken notice. Spreads remain wide, but if volatility in Treasuries eases, expect further yield tightening to ensue.
Agency Indications — FNMA / FHLMC Callable Rates
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