If this report is right then we can assume that Fed action at the high end or above this range will cause mortgage rates to dip even more & a number at the lower end or below this range will likely cause rates to reverse higher.

Following the Fed’s announcement last week rates did dip in anticipation of future easing.  The 10-year Treasury note yield dipped to around 2.50% from 2.75% earlier in the week (mortgage rates only benefited by about .125%).

However, it’s important to note that the Fed has yet to commit to any action.  They’ve only stated that they stand by ready to act if needed.  In this morning’s WSJ Jon Hilsenrath reports that the Fed is more likely to take smaller-scale and more gradual approach to quantitative easing than their last action in 2009.  If he’s right it will be interesting to see how interest rates react.

For now interest rate analysts will be closely watching the economic data that is released from now until the Fed’s next monetary policy meeting at the beginning of November.  If the economic data is grim it will strengthen the case for further quantitative easing on the part of the Fed and rates will benefit.  If it’s stronger than expected the Fed will be more likely to forgo any more stimulus which will hurt rates.

Here is a link to the full statement & here are the highlights:

*The Fed’s view is a little rosier: Since April the Fed has continually stated that economic activity would be “weak for a time.”  Today, they changed the wording to state economic activity would be “moderate for a time.”  The change in wording is sign that they believe the economy is improving.  Good news for the economy is bad news for mortgage rates.

*The Fed will stop buying mortgage-backed bonds (MBS’s): As I wrote about in my November newsletter as soon as the Fed announced that they would begin buying MBS’s in November of 2008 rates nose dived.  The Fed has been very transparent in communicating that they would discontinue this program at the end of the first quarter and they reiterated that today by stating “on March 31, the Fed will complete its purchases of $1.25 trillion of mortgage-backed securities.“  They go on to say “Fed officials believe mortgage rates could rise when it stops its purchases, but most believe it will be less than half a percentage point and possibly less.” and possibly more.  They did leave the door open to change their minds regarding this policy.

All in all the statement is reassuring from the standpoint that the Fed seems to be confident the economy is improving which means more jobs!!!!!!  The drawback is that we know that when the economy improves and the government unwinds their stimulus efforts mortgage rates will move higher.

I had planned to respond to his email privately and then figured I might as well use it as an opportunity to blog about my understanding of the financial system and to clarify how the Fed is currently using their tools to stimulate the economy.

So here we go from the top:

*What is the Fed responsible for?

Their job is threefold- 1) maintain price stability (i.e. low inflation) 2) promote full employment & 3) sustain economic growth.

*How do they go about doing this?

They effectively have three tools- 1) Federal funds rate (impacts short-term interest rates) 2) Open Market Operations (buy/ sell securities) & 3) Margin requirements (sets level at which investors can leverage security purchases)

*Currently, what is the Fed most concerned with?

Under the current economic environment the Fed’s main concerns are improving employment & economic growth. Inflationary pressures are not a concern at the current time.

*How are they going about improving employment and economic growth?

They are using two primary strategies right now. First, they have cut the Federal Funds Target Rate down to 0-.25%. As a result short-term interest rates on lines of credit and revolving credit are very low which they hope will stimulate businesses to borrow money to invest in their companies and to entice consumers to borrow money to spend on consumer goods.

Second, they are engaging in open market operations.  This is when they purchase securities from the open market.  It helps to stimulate the economy because they exchange money for securities.  The money increases the supply of money in the economy and drives down interest rates by creating additional demand for these securities and by increasing the supply of money in the economy.  The most well known operation that the Fed is currently engaged in is the TALF program which I blogged about last November. It was later expanded and can be credited for keeping mortgage rates near historic lows throughout 2009.

Each of these initiatives are designed to increase liquidity in the economy, which drives interest rates lower, and increases investment and consumption.

*Has the Fed been secretive in their initiatives?

Far from a conspiracy the Fed has been more than transparent in their action.  The TALF made headlines news when it was announced and in last week’s monetary policy meeting the Fed clearly announced that they had already discontinued the purchase of US Treasury securities and would discontinue the purchase of mortgage-back bonds early in 2010.  This is not a secret.

*As the author addresses in the article, how are their actions going to impact security prices?

When the Fed engages in open market operations they create substantial demand for the fixed-income securities that they are buying.  As a result, the value of the asset increases and the yield decreases (which is how bonds work).  Therefore, when the Fed leaves the market when their open market operations are discontinued it is likely that interest rates will move higher which will in turn push the value of existing fixed-income securities lower.

Because fixed-income securities with low coupons are more volatile than securities with higher coupons (all else being equal) we do expect these securities to take a hit.  But is this really detrimental to the “small investor” as the author suggest?

I would argue no.  First off, keep in mind that if the “small investor” was buying fixed-income securities during this crisis they probably owned fixed income securities headed into this crisis as well.  The values of their holdings rallied as the Fed began their open market operations in late 2008.  In fact, mutual funds which hold long US treasury positions were some of the top performers from 2007 to current.

Second, income investors who buy bonds under a buy-and-hold strategy have probably determined that the coupon payments they receive are sufficient to satisfy their cash-flow needs.  When rates rise the value of their underlying bond will decrease.  But, so long as the coupon is still being paid they shouldn’t care because the income will not be impacted.

Lastly, for growth investors who are concerned about capital appreciation the solution is simple right now.  Don’t purchase long-term government notes or bonds.  Instead, use shorter duration bills and bank products to make up the portion of your portfolio that you hold in fixed income securities.  As rates rise, you will then be able to re-invest the principal into higher yielding assets.

*Since the Fed is effectively creating money right now through their open market operations won’t that lead to hyper-inflation later on?

This is one of the most hotly debated topics in financial circles right now.  It is true that we find ourselves in a unique situation.  The Fed has never been in a position where they’ve created this much money.  And as I blogged about a month or so ago, according to Irving Fisher’s Equation of Exchange it is possible that as the economy improves the expanded money supply could lead to significant inflation if the Fed is unable to unwind the liquidity in time.

However, the Fed claims that they have the tools to unwind the money supply in time using tools such as reverse repurchase agreements to prevent rapid inflation.  In fact, the Wall Street Journal reported back in October that they were already testing these tools to be sure they were prepared.

In summary, fundamentally the Fed is doing nothing different today than they’ve done in the past.  The difference is that they are using their tools on a much larger scale than they’ve employed in the past.  As with any action their is a reaction and the Fed will need to be cognizant of the long-term implications their policy decisions have.  But for now, I think preventing the economy of falling into a deep recession is their biggest goal.

]]> http://evanswanson.com/rate-update/the-fed/summary-of-the-feds-current-involvement-in-the-us-economy/feed/ 0 http://evanswanson.com/rate-update/rate-update-july-21-2009/ http://evanswanson.com/rate-update/rate-update-july-21-2009/#comments Tue, 21 Jul 2009 14:56:19 +0000 Evan http://www.evanswanson.com/?p=1912 Mortgage rates appear poised to move lower this morning.  Despite positive earnings reports that have helped stocks to move higher, mortgage-backed bonds have rallied this morning thanks to comments made by Fed Chairman Ben Bernanke.

Watch today’s you tube video for details on what he said.

Click this link to view Fed Chairman Bernanke’s Op-ed piece in this morning’s WSJ.

Current Outlook: floating

Exceprt:

Q: What effect do central banks have on me?

A: The Federal Reserve is the U.S. central bank. When it cuts (or raises) its benchmark short-term interest rate, most major banks follow suit by cutting (or raising) the interest rate they charge on credit cards, home equity lines of credit and other consumer loans.

The Fed has cut rates twice this month, potentially helping U.S. borrowers. Unfortunately, today’s steep cut by the Bank of England won’t reduce your car payment or mortgage, unless you’re reading this from England.

The reason that a government guarantee helps mortgage rates move lower is because it reduces the risk of default on MBS’s for investors and therefore they are willing to accept a lower yield.

To learn more click these links-

Washington Post article

Wall Street Journal article

Blog posting on the role that Fannie & Freddie play in mortgage market

The volatility in mortgage rates has been unprecedented as of late.  From Monday of last week to Thursday 30 year fixed rates dropped from 6.25% to 5.75%.  Since Thursday to today 30 year fixed rates cycled back higher rising from 5.75% to 6.375%.

Today all eyes are on the Fed.  They will announce their interest rate decision at 2:15 EST.  Watch today’s you tube video for more information regarding this announcement.  Let us remember that a cut to the Federal Funds rat DOES NOT necessarily mean that mortgage rates will move lower.

We do believe that because of technical trading patterns it is a good idea to float into the Fed’s announcement.

Current outlook:floating

Source of chart: wsj.com

Rates are effectively unchanged this morning.

There is A LOT to talk about this morning as crisis in the financial markets persists. Here is a summary of the major stories we’re falling that are likely to impact the direction of mortgage rates:

→ AIG: The nation’s largest insurer is close to insolvency. Analysts are suggesting that the troubled insurer needs to raise $75 billion in fresh capital to stay afloat. The failure of this firm would be unprecedented because of it’s vast reach & volume of obligations. AIG operates in 130 countries and is a major player in the credit default & life insurance sector. AIG’s failure would likely cause a major disruption in the financial markets which could drag other firms down with it. Although rates may benefit from this news in the near term, in the long run this would be a disaster.

→ Federal Funds Rate: The Fed is scheduled to announce their interest rate policy decision this afternoon. Last week at this time there was a 0% chance that the Fed would alter rates. However, analysts now assume a cut of at least .25% and possibly even .50%. Remember that in and of itself the Fed cutting rates will not directly impact mortgage rates. However, what they say following their announcement can.

→ Consumer Price Index: Finally, the Labor Department released the monthly CPI report. The report came in line with expectations reflecting a 5.4% increase year-over-year. When stripping out volatile food and energy prices year-over-year inflation rose by 2.5%. Although these figures are relatively high compared to the past couple years the announcement did not surprise the markets.

Current Outlook: floating