Making Sense of Rising Rates And The Risks Ahead

The bond market returned from a 3 day weekend to find yields surging higher on Tuesday.  That pushed mortgage rates to fresh 2 year highs and added emphasis to what has already been the sharpest rate spike since late 2016.   Why are rates rising so quickly? Mortgage rates are based on mortgage-backed securities (MBS), which are essentially bonds that correlate quite well with US Treasuries.   The Federal Reserve (the Fed) has been buying both Treasuries and MBS off and on (mostly on) since 2009 as a part of various stimulus efforts.  Higher demand for bonds means higher bond prices, lower bond yields, and thus, lower rates, all other things being equal. Since the pandemic, bond buying was intended to help the US economy return to full employment and “price stability.”  By the fall of 2021, it became increasingly clear that the labor market wasn’t going to return in exactly the same form and that inflation was going to be more persistent than the Fed expected.  As such, the Fed warned that it would begin winding down bond purchases in September, ultimately pulling the trigger at the next meeting in November. There are two phases to such a wind-down.  The first involves tapering the amount of  new bond purchases. Once the Fed is done tapering, their balance sheet stops growing, but they continue to buy bonds with the proceeds from past bond purchases.  By reinvesting those proceeds, the balance sheet remains the same.  The second phase involves shrinking (or “normalizing”) the balance sheet by placing progressively smaller limits on the size of reinvestments.  
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