Weekly Mortgage Rate Review--Quantitative Easing Returns, August 13, 2010

Quantitative Easing Take Two

The big news this week was expected to be on Tuesday with the release of the statement from the Federal Reserve Open Market Committee (FOMC).  It was indeed the FOMC statement that dominated the news and influenced the markets this week. The debate among analysts prior to the FOMC meeting wasn't whether or not they would keep the target for the Federal Funds rate at 0% to .25%, but rather whether they would take any further action.  Specifically, would they announce plans for a sequel: Quantitative Easing II: The Fed Supremacy!  The answer was yes...but before I give my review of this second installment from director Ben S. Bernanke, lets review the mortgage market activity for the week.

Week in review

Monday provided no economic news and little movement in mortgage rates as traders awaited Tuesday's action from the FOMC.  Tuesday opened flat as the wait continued.  At precisely 2:15 PM ET, the FOMC statement was released and caused mortgage pricing to improve immediately.  The FOMC announced that it would keep rates low for an "entended period", that economic activity would likely be "more modest than previously anticipated", and that it would begin to purchase US Treasuries with the proceeds of maturing MBS from their portfolio.  The initial purchase of these maturing MBS was part of the Fed's initial effort at quantitative easing (defined below).   

Wednesday was a big movement day as the stock market sold off significantly in reaction to the Fed's definitive statement on the slowing US economy.  MBS prices moved strongly higher sending mortgage rates lower.  Thursday started as if the trend from the day before would continue.  However, the MBS market sharply reversed course resulting in a return of mortgage pricing to neutral for the week.  What happened?  Apparently the relatively few traders actually working this August day simply decided it was time to trade the other direction.  Significant pricing moves in one direction make traders and investors nervous, since they do not want to be over-extended on MBS issues at any certain price level.  Consequently, trading MBS pricing back to neutral for the week seemed prudent.

On Friday, we got something else to consider: the Consumer Price Index and retail sales figures.  Both came in close to expectationsleaving mortgage pricing to other factors.  MBS prices did improve and hold their improvements during the second half of the trading day primarily in response to negative comments from Kansas City Fed President, Thomas Hoenig.  Mr. Hoenig believes that the Fed policy of keeping interest too low is a "dangerous gamble".  He also is opposed to more Fed Quantitative Easing.

For the week mortgage pricing was modestly better.

Next week

Data from the Empire State Manufacturing Index, housing starts, industrial production and the Producer Price Index will guide rates.

Some sequels improve on the original while many more bomb

"Quantitative Easing" (QE) is the fancy name used by central bankers for a strategy they employ when faced without the ability to lower interest rates further to stimulate the econmy. QE involves putting more money into the economy by buying the securities assets of banks and other financial insitutions.  In theory these banks would receive cash for their targeted securities, thereby putting them in a stronger capital situation, which in turn could lead to additional lending.

In 2008 the original QE feature debuted when the Fed announced plans to purchase up to $750 billion of MBS to stabilize the housing sector, shore-up the banks capital structure and stimulate lending.  The first two goals were largely obtained but the final goal has been elusive.  Banks have simply utilized their new capital to purchase US Treasuries and earn a modest return with essentially no risk.  In a world in which a no-risk investment pays a guaranteed return why would banks increase lending, an activity frought with risk?  Easy answer...they won't.

In the sequel, the Fed intends to take a different approach using the proceeeds from their maturing MBS portfolio to purchase US Treasuries from banks and other financial institutions.  Early critics have contended that this new round of QE will be no more effective at increasing lending activity than the first round, claiming that the problems in the economy are more a fuction of structural issues (oversupply of residential and commercial real estate, inappropriate industrial capacity, borrower creditworthiness and labor imbalances) than a lack of credit availability to individuals and businesses. 

But I think the critics miss an important distinction; this time QE will be based not on MBS purchases but rather on the purchases of government securities.  By effectively controlling the supply of such securities in the market place, the Fed will control their price.  With government securities providing a lesser return, banks may look for better returns from increased lending.  The critics also say that trying to stimulate lending activity is trying to take us back to the system that failed...one based on leverage.  To me this is simply naive, since credit and borrowing are essential in any growing economy.  The financial regulatory reforms that are taking place and the Fed's own statement that they are intending to maintain a steady-sized balance sheet, are indications that we will not see a return to the wild west in lending.

What our economy needs is stabile, steady growth.  But make no mistake, growth is essential.  It will take time to sort through the structural problems in our economy, but we are doing so.  Banks continue to process through the troubled loans in their portfolios, modifying terms, foreclosing or accepting short sales, yet home prices are stabilizing.  Businesses are retaining cash.  Individuals are paying down debt and improving their credit scores in the process.  We are working through the process but it will take time.  QE II is not a cruiseliner docked in Long Beach, CA, but rather the second installment in a dramatic project that ultimately may be viewed as supreme.