Morning Report: The Fed does a hawkish pause

Vital Statistics:

Stocks are lower this morning after the Fed decision. Bonds and MBS are down.

As expected, the Fed maintained interest rates at current levels and signaled one more hike for this year. They increased their GDP forecasts for 2023 and 2024, while taking down their unemployment and inflation projections. They bumped up their estimate for the Fed Funds rate in 2024 and 2025 by 30 basis points and 20 basis points respectively.

The dot plot comparison is below:

During the press conference, Powell was asked repeatedly why the forecast for the Fed Funds rate going forward is increasing when the forecast for inflation is falling. His answer was that the unobservable neutral rate (r star) might have risen, which means the Fed has less leeway to lower rates without triggering inflation.

If r-star has increased, it would mark the official escape from the post global financial crisis deflationary trap and a return to the more normal interest rate environment we saw before 2007. Of course this is merely a theory, and a lot of things could derail this, particularly some sort of financial black swan event. The real estate collapse in China is a big potential driver there, especially if losses at Chinese banks trigger counterparty issues in Western ones. Regardless, the one takeaway is that the Fed isn’t riding to the rescue of the US housing market any time soon.

What does this mean for mortgage rates? Theoretically the Fed just signaled a lot lower interest rate volatility going forward, which should translate into tightening MBS spreads. On the other hand, the yield curve is still highly inverted and we could see that unwind as the hard landing scenario becomes less probable.

Existing home sales fell 0.7% MOM and 15.3% YOY to a seasonally-adjusted annual level of 4.04 million (house not found). “Home sales have been stable for several months, neither rising nor falling in any meaningful way,” said NAR Chief Economist Lawrence Yun. “Mortgage rate changes will have a big impact over the short run, while job gains will have a steady, positive impact over the long run. The South had a lighter decline in sales from a year ago due to greater regional job growth since coming out of the pandemic lockdown.”

The median house price rose 3.9% YOY to 407,100. The NAR estimates that the supply of houses has to basically double in order to stem home price appreciation.

The Index of Leading Economic Indicators fell in August, following a decline in July. The Index of Leading Economic Indicators has been consistently bearish on the US economy for the past six months. “With August’s decline, the US Leading Economic Index has now fallen for nearly a year and a half straight, indicating the economy is heading into a challenging growth period and possible recession over the next year,” said Justyna Zabinska-La Monica, Senior Manager, Business Cycle Indicators, at The Conference Board. “The leading index continued to be negatively impacted in August by weak new orders, deteriorating consumer expectations of business conditions, high interest rates, and tight credit conditions. All these factors suggest that going forward economic activity probably will decelerate and experience a brief but mild contraction. The Conference Board forecasts real GDP will grow by 2.2 percent in 2023, and then fall to 0.8 percent in 2024.” Note the Fed sees 2.1% growth this year and then 1.5% in 2024.