Here's a quick recap, if you haven't already heard: mortgage rates just spiked above 5%, Treasury yields keep surging, and this is after a quarter in which we saw a bond rout "of historic proportions," as Morgan Stanley's Lisa Shalett put it, with losses of "a staggering 9.5%, the worst in nearly 50 years."
We are only just beginning to get a glimpse of the fallout--some might say havoc--this will all create. Mortgage applications have collapsed 40% from a year ago. (We talked already about how badly the lending stocks have traded--they absolutely foretold the rout that was coming.) Mortgage rates loosely track the 10-year Treasury yield, and that relationship has gotten a lot "looser" lately. Spreads have widened as investors back away from the asset class, spooked by the Fed's need to rapidly reduce its balance sheet.
So you've got Treasury yields surging, mortgage rates surging even more, and comments like we got from Lael Brainard yesterday adding fuel to the fire. Brainard--one of the more dovish Fed members--explicitly said in a speech that the central bank needs to reduce its nearly $9 trillion balance "at a rapid pace as soon as our May meeting...[and] considerably more rapidly than in the previous recovery." As Aneta Markowska of Jefferies told us, that should translate to about a trillion dollars of shrinkage per year.
And that can largely happen with the Fed letting existing holdings of Treasuries and mortgage bonds "roll off," or mature, without replacing them--as opposed to having to actually sell from its portfolio, which would be a much bigger headache for markets. You just don't have the dealer capacity on the street that you used to, Andy Brenner of Natalliance has warned us ("Tapering When Wall Street is Shrinking"). And the Fed's mortgage holdings also dwarf what the private sector could take on right now, Walt Schmidt of FHN told us last week.
Not to mention, the Fed could end up selling its bonds at a loss, which is an awkward position for the central bank to find itself in. In fact, even without facing that loss, the Fed itself faces higher costs from higher rates. The Fed "has gone from being a slight net lender to the U.S. financial system in 2007, to a net borrower of almost $6 trillion...[which] means the Fed itself has probably the single biggest exposure of any global financial player to the impact of rate hikes," I wrote last year.
And of course, the U.S. government itself faces rising borrowing costs at a time when its debt has soared from getting through the pandemic; the national debt surpassed $30 trillion in January. Yields are already above what the White House projected for this year, and because we are still running budget deficits, every increase in debt servicing either adds to the debt or crowds out other government spending. And yet, the Biden administration just announced it will also be extending student loan payment relief for the sixth time--which has already cost around $100 billion.
What happens if the Fed's Esther George is right, that if not for the Fed's quantitative easing, bond yields would be 1.5 points higher on the 10-year Treasury? Investors, in other words, are starting to wonder--and test--if we are heading not just to 2.75% or 3%, but perhaps even 4%, as her analysis would imply. ("The bond vigilantes are back," wrote Brenner this morning, as the 10-year spiked over 2.6%.) Certainly, the Fed's jawboning about shrinking the balance sheet more aggressively is playing into that narrative and driving the recent rise in long-end rates.
What would happen to the mortgage market, the national debt, corporate borrowing and a zillion other things in that kind of environment? Maybe we'll never know, and markets will settle back down, and we'll roll our eyes that we ever contemplated a 7% mortgage rate. Or maybe, we'll be facing down that reality sooner than we ever would have dreamt.
See you at 1 p.m!