Will Mortgage Rates Soar As Fed Programs Wind Down?

Fed Support No Longer Unlimited

There seems to be near unanimous agreement at all levels of government that a recovery in housing prices is essential for economic stabilization and future growth.   The Federal Reserve has supported this effort by driving short term interest rates to near zero and initiating a program to purchase as much as $1.75 trillion in mortgage debt and treasuries.  As of mid year, the Fed had purchased over a half trillion dollars of mortgage-backed securities and housing agency debt in an attempt to keep mortgage rates low.

How much longer will unlimited Fed support for the housing market continue and will mortgage rates increase when Fed support is withdrawn?  The Federal Reserve has indicated that the credit markets have stabilized.  The Federal Reserve’s balance sheet has been shrinking for weeks and is now below the $2 trillion level reached in March.   With financial Armageddon apparently no longer an immediate threat, the Fed also seems to be responding to political pressure to reduce various emergency lending programs.

In response to pointed warnings from foreign creditors about monetizing US debt,  Chairman Bernanke said:

WSJ – “We absolutely will not monetize the debt,” Mr. Bernanke says, using economist-speak that means he won’t let the Fed become the government’s source of cash for deficits. Fed-fueled deficits would be inflationary. Mr. Bernanke says, “we will not abandon price stability.”

In addition, the Fed faces a full assault on its authority from Ron Paul who is attempting to introduce legislation to audit the Fed.  Many other members of Congress have also been critical of the cost and secrecy of Federal Reserve programs and bailouts.

WSJ – As Mr. Bernanke heads to Capitol Hill today for two days of testimony on the economy, the central bank is fending off attacks on many fronts from critics who want to rein in its power and autonomy.

Rallying one charge is Ron Paul, an iconoclastic Texas Republican who wants to abolish the central bank entirely.

Still, Mr. Paul has persuaded nearly two-thirds of the House to co-sponsor a bill requiring far-reaching congressional audits of the Fed. Audits would show “that it’s the Fed that has caused all the mischief” in the U.S. economy, Mr. Paul says.

Mr. Bernanke will face a tough audience in his semiannual report to Congress Tuesday and Wednesday. The Fed “went too far in bailing out companies and exposing taxpayers” to the costs, says Sen. Richard Shelby of Alabama, the senior Republican on the Senate Banking Committee. “They utterly failed the American people as a bank regulator.”

Outlook For Mortgage Rates

With the credit markets stabilized and the Fed under political pressure to reduce its multi trillion dollar financial  commitments, how will mortgage rates respond as the Fed reduces its programs to keep rates low?  Two top rated bond managers at Pimco and American Beacon Advisors have similar opinions.

July 20 (Bloomberg) — Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., reduced holdings of mortgage debt last month and added to cash and equivalent securities.

Gross cut the $161 billion Total Return Fund’s investment in mortgage bonds to 54 percent of assets, the lowest in almost two years, from 61 percent in May, according to a report on Pimco’s Web site.  Gross trimmed holdings of government-related bonds to 24 percent of assets, the least since February, from 25 percent.

Gross has been selling mortgage-backed securities over the past few months after loading up on them last summer in the midst of the financial crisis, which started with the collapse of the U.S. property market in 2007.

AMERICAN BEACON ADVISORS’ BOND MAVENS, Kirk Brown and Patrick Sporl, have done an admirable job of flying their respective fixed-income funds, AB Treasury Inflation Protected and AB Intermediate Bond, through the credit-market turbulence of the past two years.

He thinks that stagflation — the dreaded combination of a stagnant economy and inflation — is more of a possibility now than at any time since the 1970s.

AB Intermediate Bond, meanwhile, is underweight mortgage-backed securities and overweight corporates.

A reduction of the Fed’s massive intervention in the mortgage market is certain to result in higher mortgage rates, but will not be the disaster that some fear.   The real disaster has already occurred based on the Fed’s past policy of ultra low interest rates to increase lending and inflate housing prices.

Disclosures: No positions

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