Monday Musings: May 9, 2022

May 09, 2022

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Public Trust Credit Team
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Mortgage rates are going up, but they might be moving too slow

The Federal Reserve is counting on mortgage rate increases to mitigate the highest inflation we have seen in four decades, but underlying demand remains strong and housing prices are continuing to climb. Expensive home prices and rising rates are now pushing out some buyers, but the elevated demand combined with the lack of supply is still applying upward pressure on prices. Cash buyers and similar home investors are shielded from rising mortgage rates, and they are now beginning to bid against each other as the competition pool thins. According to the National Association of Realtors, the median selling price of an existing home rose 15% in March from a year earlier, leaving policymakers to walk a thin line; increasing the rates too quickly may ease growth and relax price jumps but carries the risk of tipping the economy into a recession. If the Fed wants to see the trend reverse, they may have to push their finger down even harder than they already have. 

The Fed increased the overnight rate by 50 basis points last Wednesday, but market participants are still largely unsure if the current pace of hikes will be enough to cool inflation. The housing market now serves as a key metric regarding whether the central bank has done its job or if it needs to go even further. According to Freddie Mac, the average rate for a 30-year fixed-rate mortgage stood at 5.1% in the final week of April, a 2% increase from the start of the year. The inventory of unsold existing homes in the U.S. stands at 900k homes, a stark decline from the 1.6 million inventory just two years prior. On a similar note, U.S. homebuilder sentiment fell to a seven-month low in April, as the rising rates and increased prices led to declining sales and prospective buyer traffic. The implemented Fed rate is not a one-for-one correlation to mortgage rates that are more similarly tied to the 30-year Treasury bill rate with similar times to maturity. As the rising rate environment slowly trickles through the U.S. housing market, we believe supply, demand, and overall prices will eventually return to equilibrium levels, just at a slower pace than originally thought.

Looming quantitative tightening in a rising rate environment

Over the last ten years, quantitative easing (QE) has become more frequently used by the Federal Reserve as a tool to enact its monetary policy. The goal of QE is to inject cash into the financial system in order to encourage lending and investments while keeping borrowing costs low. During the pandemic, the Fed more than doubled its portfolio of primarily treasury and mortgage securities in an effort to support financial markets and the economy. In response to rising inflation and in an effort to curtail an overheated economy, the Fed announced last week that it plans to tighten financial conditions through increases in interest rates in conjunction with the implementation of quantitative tightening (QT). Historically, the Fed has enacted QT through a passive shrinking of its portfolio by allowing bonds to reach maturity and not reinvesting the proceeds. In response to the current economic climate, bond redemptions are expected to be larger and faster than what has been utilized over the past decade. Officials have publicly discussed plans of shrinking the Fed’s $9 trillion portfolio by approximately $3 trillion over the next three years by allowing $95 billion in securities to mature each month (higher than the $50 billion cap previously implemented for QT from 2017-2019). The Treasury will continue selling new securities and since the Fed will be purchasing less under QT, additional market participants including banks, foreign investors, and other financial institutions will purchase those securities from their own reserves, reducing the overall money supply in the market.

Just as the Fed’s QE efforts supported a low interest rate environment, QT is expected to put pressure on rates to rise as the money supply decreases. Uncertainty remains whether QT in conjunction with increasing interest rates will be sufficient to combat high inflation without provoking a prolonged economic downturn, but an increasing rate environment will change the marketplace and could prompt investors to pivot towards investments that provide a higher yield for lower risk.

ECB increases capital charges on banks with large leveraged loan balances

The European Central Bank (ECB) has stepped up enforcement actions against banks with large exposures to leveraged loans. Since 2017, the central bank has issued guidance detailing the concerns it has with the loans while attempting to limit the amount of exposure banks could have to this asset class; the ECB claims this guidance has not been followed as strictly as it would like and has begun issuing capital charges to certain Globally Systemic Important Banks (G-SIB). Deutsche was the first bank to see a capital charge from its exposure and now Credit Agricolel as well, though the largest leveraged lender (BNP Paribas) has yet to see a capital charge. Leveraged loans usually represent riskier debt issued to companies and are generally syndicated amongst banks and investors, spreading out the total credit risk. Low rate environments across the globe have spurred plenty of lending in the space as companies tap the market for cheap debt though most leveraged loans have floating rates. The ECB’s concern is that as rates rise defaults will uptick and banks could begin to see losses related to their exposure either directly or through securitized products. So far, most of the large banks have balked at the ECB’s stance, saying that their accounting overstates the exposure and that default rates remain very low. While Fitch also expects default rates to remain low, increasing to about 2.5% this year from 0.5% last year, we expect the ECB to remain bearish on leveraged loans and could see more capital charges being issued to exposed banks. While capital charges from central banks can weigh on profitability, they do create more loss-absorbing capital that tends to be positive for debt holders.

All comments and discussion presented are purely based on opinion and assumptions, not fact. These assumptions may or may not be correct based on foreseen and unforeseen events. The information presented should not be used in making any investment decisions. This material is not a recommendation to buy, sell, implement, or change any securities or investment strategy, function, or process. Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is not an indication of future performance. Any financial and/or investment decision may incur losses.

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