Rick Shane: Got it. Yes. And that really does get to the punchline, which is that as you’re looking forward to all of those factors, that’s really what’s dictating the dividend policy and…
Peter Federico: I appreciate that clarification. That’s exactly right. It’s setting the dividend policy based on the level of return from an economic perspective that we’re seeing as opposed to the current period earnings – that gets reflected in our net interest margin.
Rick Shane: Okay, thank you very much.
Peter Federico: Sure. Appreciate the question.
Operator: Our next question comes from the line of Terry Ma with Barclays. Please go ahead.
Peter Federico: Good morning, Terry.
Terry Ma: Hey, good morning. Thank you. So you mentioned that you thought the recent volatility would be short-lived. Can you maybe just give a little bit more color on what gives you confidence that it will be short-lived – and then maybe just your expectations on where near-term spreads are set once the volatility this year?
Peter Federico: Sure. Both Chris and I tried to address this to some extent in our in our prepared remarks. And I think Chris referenced the fact that this quarter looked a lot different than previous quarters when we had similar moves. And that’s really a critical point from our perspective. What occurred in the first quarter was generally a very stable market conditions, but there was a very significant repricing of the timing and magnitude of short-term rate moves from the Fed. Importantly, it was not a shift and has not yet become a shift in paradigm with respect to monetary policy. Said another way, the Fed was really clear in a number of communications that the policy rate was likely at its peak and the next move was likely going to be an ease.
What we had in the first quarter was simply a plateauing of CPI data – it came in at 3.9% and then 3.8% and 3.8% again. It just didn’t show the improvement that the Fed was looking for. And in the 2 or 3 days following each of those CPI reports the 10-year treasury moved up 20 to 25 basis points and at stance taking out one. So when we started the year, the market probably incorrectly so, may be too optimistic, expected the Fed to ease 5 or 6x. Now as we sit here today, the market has repriced to only 1.5 moves this year and importantly, in aggregate, the Fed funds futures in 2027 tell us there’s only six moves in total, meaning that the Fed funds rate now according to the market’s projections is going to settle out at around 4%. That’s materially higher than what the Fed’s own long-run target is, which is still 2.5%.
So what we had occur is a very significant repricing of the path of short-term interest rates. We did not have a paradigm shift. If inflation continues to not evolve or reaccelerate, there could be a shift in monetary policy. We don’t believe that’s going to happen. We get important inflation data at the end of this week in the PCE report. But we believe, and I think the Fed still believes that inflation will show signs of improvement. We will move more toward the Fed’s long-run target, which, by the way, the Fed’s own estimate of PC at the end of this year, is 2.6%. That’s not going to be materially off where the number comes out at the end of this week. And with that projection, the Fed expected to remove. So we think that where the 10-year is at, call it, 4.5 to 4.75.
That seems like a pretty healthy place for the 10-year in the context of a Fed funds target that’s ultimately going to move to 3%. We think the inflation report ultimately come in favor of the direction the Fed ones. And I think this repricing has simply been just a healthy movement of where short-term rate cuts are going to occur and the magnitude of those, not a paradigm shift. And so spreads moved. We had a lot of geopolitical risk. We had volatility following inflation reports. If we get two or three inflation reports that are at or better than expected, we’ll have the same sort of significant repricing in the opposite direction. I think the Fed is looking for 2 or 3 months in a row of better data to have sufficient confidence. And once they get that data, then everybody will be pricing in the eases again and the direction of monetary policy will be clear again.
Right now, it’s a little uncertain, but we think the repricing is largely over. With respect to spreads, you asked that. Again, when you look at current coupon spreads near the middle of the range, that seems like a good place from our perspective. Current coupons of the 5-and 10-year treasury at 150 to 160 basis points seems like a healthy place against swaps, 180 to 190, seems like a healthy place. We do have some negative seasonals right now between this next April and May should be kind of the worst seasonal months for mortgages in terms of origination. So the market sort of, I think, is in a good place right now with the repricing that has taken place.
Terry Ma: Got it. Thank you. Very helpful color. And then just on your hedge ratio and your duration gap, you guys took the hedge ratio down and you’re now running a slightly positive duration gap. So maybe just a little bit more color on that move and then talk about where you’re comfortable running the book in this environment.
Peter Federico: Sure. I’ve talked about this for a while. It does make sense for us to gradually move our hedge ratio down as the Fed’s monetary policy outlook changes. We obviously wanted to run with a very high hedge ratio. More than 100% of our short-term debt essentially termed out in order to protect our funding cost in a rising short-term rate environment. We’re now at the inflection point – and so over time, I would expect that to come down. And as we get more confidence when and the magnitude of the Fed cuts, then we’ll ultimately probably operate with even a lower hedge ratio such that at some point in the monetary policy easing process we would want to operate with, in a sense, some percent of our short-term debt unhedged, have that – a bigger part of our funding mix.
So over time, we’ll do that. Chris mentioned, and I’ll let him speak to this. He mentioned our gradual movement to more towards swaps in our hedge mix. And I think we have a sort of a positive outlook. Chris, do you want to talk a little bit about that?
