MBS Live Morning: End of an Era For MBS (Part 4)


Today marks the conclusion of the Fed’s post-covid balance sheet expansion.  In other words.  Tapering is complete.  Before covid, the Fed enacted quantitative easing campaigns (direct purchases) in the MBS market 3 times.  The third time was MBS-specific (i.e. it didn’t include new money for Treasuries), and it was open ended.  This set the bond market up to have a tantrum in 2013 when the Fed finally announced the tapering of those purchases.  It wasn’t until 2017 that the Fed finally began normalization (decreasing its MBS holdings).  This is different from tapering which merely decreases the pace at which the Fed is growing its balance sheet.  This time around, the Fed tapered more quickly and it intends to begin the normalization process MUCH sooner than it did last time.  The effect on MBS has been plain to see.

What’s up with the big spike in 2020?  This, of course, was the most noticeable onset of the pandemic in the US and it created catastrophic conditions in financial markets.  It can safely be disregarded for the purpose of tracking the shift in mortgage vs Treasury performance. With that out of the way, we can see just how big a deal the past few months have been for the mortgage market.  It’s the most abrupt spike in underperformance since the first 3 months of 2008 during the mortgage meltdown.
In broader bond news, this week has been the worst for Treasuries since 2016, but notably only because the previous week was exceptionally strong.  If we throw out last week, the change from 2 Fridays ago is pretty minimal.

In essence, the market has quickly returned to pricing in an aggressive Fed rate hike campaign in 2022, even if it sees much lower odds for a 50bp hike in next week’s Fed meeting.  Notes on interpreting the following chart:

the closer the line is to one of the dotted level lines, the more the market anticipates that level for the Fed Funds Rate.  In other words, at one time, a 50bp hike was slightly more likely than a 25bp hike for next week’s meeting. 
Only the first two tiers have “bps” attached as the 25bp vs 50bp debate only pertained to the March meeting, and there was never any crazy claims about a potential 75bp hike. 
Remember that the Fed sets rates in 25bp increments.  The current Fed Funds Target Rate is 0.00-0.25% (hence .25-.50% would require a single 25bp hike).
You can safely ignore the y-axis labels, which merely refer to the Fed Funds Futures prices.  I’ve already done the work for you of translating them to rate hike ranges.

Why has the rate hike expectation ramped back up to its recent maximum levels despite Ukraine (i.e. blue line is at its lows)?   In a word, inflation.  Indeed, 10yr yields would still be down in the 1.7% range were it not for the quick ramp in inflation expectations:

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