Trading Desk Talk

First-half review
Second-half outlook

First-half review — To borrow the title of a song from The Kinks: Where have all the good times gone? The first half of 2024 is now in the rearview mirror. Below, we look back at what the past six months have meant for the Federal Reserve (Fed), interest rates, and mortgage-backed securities (MBS).

Federal Reserve

Reread transcripts from the final days of 2023, and you’ll certainly see that some Fed officials were advocating for rate cuts. But the transcripts also show that many more officials, including Chair Jerome Powell, were still seeking additional data before committing to cuts. In this respect, the consensus and rhetoric (see below) at the Fed remained largely unchanged over the first half of 2024.

Representative quotes from Fed officials at the end of 2023:

• Patrick Harker, president of the Philadelphia Fed: “It’s important that we start to move rates down. We don’t have to do it too fast, and we’re not going to do it right away.”
• Raphael Bostic, president of the Atlanta Fed: “For me, I’m thinking inflation is going to come down relatively slowly in the next six months, which means there’s not going to be urgency for us to pull off our restrictive stance.”
• Loretta Mester, president of the Cleveland Fed: “[Markets are] a little bit ahead [of the Fed in betting on rate cuts in early 2024].”

Recent quotes from Fed officials:

• Jerome Powell, Fed chair: “Because the U.S. economy is strong and the labor market is strong, we have the ability to take our time and get this [interest rates] right…and that’s what we’re planning to do.”
• Mary Daly, president of the San Francisco Fed: “Core PCE inflation data indicate monetary policy is working, though it’s too early to tell when it will be appropriate to lower interest rates.”
• Michelle Bowman, Fed governor: “We are still not yet at the point where it is appropriate to lower the policy rate … Given the risks and uncertainties regarding my economic outlook, I will remain cautious in my approach to considering future changes in the stance of policy.”

As these and other quotes show, the major change in outlook since late 2023 didn’t come from the Fed, but from the market. With a federal funds spot rate of 5.33% heading into 2024, the market had a 3.84% policy rate projected by yearend. This equated to about six rate cuts of 25 basis points (bps) each. Today, however, the December federal funds rate futures contract is 4.92%—which equates to only two 25 bps cuts for the remainder of 2024. And the federal funds spot rate is still 5.33%.

Interest Rates

For much of 2024, the market for Treasuries has been under pressure, as it faced strong economic fundamentals and increased supply from massive government deficits. The labor market, for example, expanded by 1.24 million jobs in the first half of 2024. This was a slower pace than in 2022 and 2023, but strong enough to allow the Fed to leave interest rates higher for longer to fight inflation.

That fight seems to be working lately—both the Personal Consumption Expenditures (PCE) price index and the core PCE price index are on the decline. The main question now surrounds the Fed’s ability to deliver a soft landing, where unemployment remains below 5% and inflation subsides to 2%.

As economic fundamentals gradually weaken, the probability of 25 bps rate cuts in both September and December 2024 currently hovers above 75%, according to Bloomberg and federal funds rate futures. Indeed, since the beginning of May, the yield on the benchmark 10-year Treasury note has trended downward in anticipation of looser monetary policy (Figure 1).

MBS Spreads

Ginnie Mae (GNMA) project loan spreads have largely tightened in 2024 (Figure 2) amid low new-issue supply, as well as confidence that the bulge of MBS held by the Federal Deposit Insurance Corporation (FDIC) has been put to rest, and optimism that the regional banking crisis of early 2023 is behind us. Project-loan spreads are approaching their long-term average, after nearly breaching a two-standard deviation (SD) rise in early 2023. The GNMA investor base has maintained confidence that bank-buying appetite will reemerge. When it does, steady streams of collateral will be needed to satisfy demand. So far, however, that emergence has been tepid at best.

Fannie Mae (FNMA) Delegated Underwriting and Servicing (DUS) loans have fared better than Ginnies, largely due to a deeper buyer base and greater liquidity. Still, the two MBS markets are correlated—while we have experienced spread tightening throughout much of 2024, we expect tougher roads ahead. In both products, investor spreads have nearly returned to their long-run averages (Figure 3). This signifies that valuations are neither rich nor cheap from an investor’s perspective. Borrowing rates, on the other hand, are relatively rich—coupons are currently in the top quartile of the past seven years.

Second-Half Outlook

Recent experience suggests that it is better to take the Fed at its word if the latter clashes with the market’s view. Fed officials continue to insist that rates will remain high unless inflation is clearly on a sustainable path to 2%. Barring a significant labor market weakening or a catastrophic geopolitical event, we therefore expect the Fed to hold steady on rates for the foreseeable future.

Interest rates remain generally higher than 10-year norms. Nevertheless, they seem poised for improvement—especially if the aforementioned monetary policy/interest rate scenarios play out as expected. According to a composite by Bloomberg of the forecasts of more than 70 economists, interest rates will continue their downward trajectory for the next 18 months (Figure 4).

In the near term, we expect MBS spreads to maintain a weakening bias. Renounced optimism in the agency MBS space—stemming from a lack of follow-through by bank investors in mass—has left broker-dealer balance sheets full. We expect our investors will, at a minimum, maintain inventory for the eventual return of bank buyers. But we don’t expect a euphoric event that would cause spreads to tighten dramatically.

FROM THE DESK

Agency CMBS — It was a quiet week, as expected, given the Independence Day holiday. The temperature of our market was outlined above: There is cautious optimism that investor demand will increase eventually.

Municipals — AAA tax-exempt yields were relatively flat across the yield curve, week-over-week. With the holiday shortened week, the market was relatively quiet with no multifamily or healthcare deals priced.  However, the first half of 2024 ended with $236 billion of primary new issuance—the most ever in the first half of a year. 

Economic Calendar for the Week Ahead

Summary of Global Fixed-Income Markets

The information contained herein, including any expression of opinion, has been obtained from, or is based upon, resources believed to be reliable, but is not guaranteed as to accuracy or completeness. This is not intended to be an offer to buy or sell or a solicitation of an offer to buy or sell securities, if any referred to herein. Lument Securities, LLC may from time to time have a position in one or more of any securities mentioned herein. Lument Securities, LLC or one of its affiliates may from time to time perform investment banking or other business for any company mentioned.