Investors fear ongoing moves by the Fed and other central banks to raise short-term interest rates to fight inflation could lead to a recession.

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After taking Wednesday’s Fed rate hike in stride, investors lost their appetite for bonds Thursday in a selloff that pushed mortgage rates to new 2022 highs.

Bond markets regained their footing Friday, with yields on 10-year Treasurys, a barometer for mortgage rates, retreating from a high of 3.77 percent. Strong investor demand for bonds and mortgage-backed securities pushes their prices up, and yields down.

But the renewed demand for bonds Friday could prove to be short-lived, if driven by a transitory flight to safety by investors. Former Dallas Fed President Richard Fisher told CNBC that he expects yields on 10-year bonds to hit 4 percent by the end of the year.

Stocks plummeted Friday on fears that, as the war in Ukraine drags on, ongoing moves by the Fed and other central banks to raise short-term interest rates to fight inflation will ultimately lead to a recession.

“The market thinks the economy will slow faster than the Fed does,” Mark Cabana, head of U.S. rates strategy at Bank of America, told the New York Times.

Mortgage rates hit new 2022 highs

The Optimal Blue Mortgage Market Indices, which are updated daily, showed rates for 30-year fixed-rate mortgages hitting a new 2022 high of 6.4 percent on Thursday.

While rates on 30-year fixed mortgages surged above 6 percent in June on similar fears, by Aug. 1 they’d retreated to 5.26 percent, with investors in mortgage-backed securities wagering that inflation would ease and the Fed would slow the pace of interest rate hikes.

But mortgage rates and Treasury yields have been on a steady upward climb since Aug. 1, as Fed policymakers continued to telegraph their determination to fight inflation “forcefully,” even if that brings “some pain to households and businesses.”

At the conclusion of their latest two-day meeting this week, Fed policymakers made clear that they’re prepared to continue hiking the short-term federal funds rate to reach a target of 4.4 percent by the end of this year, and keep rates high until inflation comes down.

Economists at Fannie Mae expect a fourth 75-basis point hike in November, and a 50-basis point hike in December, to reach the target for the fed funds rate.

“This is above our most recent rate expectations, though we have long forecast that the Fed would need to tighten monetary policy aggressively to combat inflation and, in doing so, would likely cause the economy to fall into a recession in 2023,” Fannie Mae economist Nathaniel Drake said in a note Friday.

While markets for Treasurys and mortgage debt took the news in stride Wednesday, a big selloff in bond markets pushed Treasury yields and mortgage rates up Thursday.

While central banks in Britain, Sweden, Switzerland and Norway also raised rates, “it was the Fed’s signal that it expects high U.S. rates to last through 2023 that sparked the latest sell-off,” Reuters reported.

At a press conference Wednesday, Fed Chair Jerome Powell seemed intent on quelling speculation that the Fed will ease up on rates anytime soon, noting that the Fed doesn’t see inflation coming back down to the Fed’s target of 2 percent until 2025.

“So far there is only modest evidence that the labor market is cooling off,” Powell said. “Job openings are down a bit. Quits are off their all-time highs. There’s signs that wage measures may be flattening out. Payroll gains have moderated, but not much.”

In a note to clients Friday, Pantheon Macroeconomics Chief Economist Ian Shepherdson said his firm’s forecasts “suggest that the economy will not dip into recession.”

But Shepherdson said the fact remains “that the Fed clearly wants the labor market to weaken quite sharply. What’s not clear to us is why. We think inflation will plunge over the next year as margins re-compress, in the wake of rapidly normalizing supply chains, to the point where an undershoot in core PCE [personal consumption expenditures] inflation next summer is a real possibility.”

Rates not expected to ease

Source: Fannie Mae Housing Forecast.

Economists at Fannie Mae are taking the Fed for its word that it’s not backing down on monetary policy tightening.

In an August forecast, Fannie Mae economists predicted that rates on 30-year fixed mortgages had likely peaked during the second quarter at 5.2 percent, and would retreat for five consecutive quarters to an average of 4.4 percent during the second half of 2023.

But in their September forecast, Fannie Mae economists said they now see mortgage rates peaking at 5.7 percent during the last quarter of this year and the first quarter of 2023, before easing slightly to 5.5 percent by the final three months of next year.

If there was one silver lining for mortgage rates to come out of this week’s Fed meeting, it’s that Powell said there are no plans to accelerate “quantitative tightening” to trim the central bank’s nearly $9 trillion balance sheet.

Fed’s balance sheet

Assets held by the Federal Reserve through quantitative easing purchases now include $5.67 trillion in long-term Treasurys and $2.71 trillion in mortgage-backed securities. Source: Board of Governors of the Federal Reserve System, Federal Reserve Bank of St. Louis.

The Fed is currently shedding $60 billion in Treasurys and $35 billion in mortgage debt each month by letting expiring assets roll off the books. In the past, Fed policymakers have said they would also consider selling Treasurys and mortgage debt if needed to accelerate tightening, which would put more upward pressure on mortgage rates.

“It’s not something we’re considering right now and not something I expect to be considering in the near term,” Powell said Wednesday. “It’s something we will turn to, but the time for turning to it is not close.”

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Email Matt Carter

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