Federal Reserve & Interest Rates

To no ones surprise the Federal Open Market Committee voted unanimously to leave interest rates unchanged today at their regularly scheduled meeting.  With economic activity starting to pick up, many investors believe the Fed may start their exit strategy fairly soon but at the same time keep rates low for some time to give a chance for the employment situation to improve somewhat.

To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt.  The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010.  As previously announced, the Federal Reserve’s purchases of $300 billion of Treasury securities will be completed by the end of October 2009. 

The purchases of agency mortgage securities was originally scheduled to finish up by the end of the year but slowing the pace of their purchases by another quarter makes sense as it gives more time for the financial situation to improve.  The Fed is hoping there will be investors who will be able to pick up the slack once they leave the market.

A jump in mortgage rates may be impossible to avoid once they finish up their purchase program and while the housing market has shown some signs of improving in the past few months, it still has a ways to go before it returns to normal.   The Fed has also announced that it will gradually shrink it’s credit facilities to financial institutions which they created in the aftermath of the Lehman collapse last year.

The Fed plans to wrap up their purchases of Treasury securities sometime next month and it will be interesting to see what effect it will have on yields once they leave the market.  Foreign demand remains strong for the time being so yields shouldn’t rise too much but even that is uncertain.

The Fed will likely keep a close watch on inflationary pressures and make an changes to their exit strategy as needed.

With increasing investor sentiment that the economic recovery is gaining steam, many bond analysts are predicting a subsequent rise in Treasury yields.  Coupled with the fact that the Fed will be ending it’s program to purchase up to $300 billion in Treasuries sometime in October, there is a general feeling that yields have no where to go but up.

We likely going to see more and more investors leaving the safe haven of Treasuries and seeking higher returns in the next few months.  The Fed is still expected to keep it’s targeted Federal Funds rate at between 0% and .25% when it meets this week.

As talk of the government’s exit strategy also gains steam we are also likely to see traders start to price in future Fed rate hikes, although that’s still premature at this time.  Based on futures options most investors believe the Fed will keep rates at their current level at least until next summer or fall.

However, unless the economy starts to falter once again, the forces behind higher yields are likely to gain in strength over the next few months.  There’s going to be a lot of Treasury supply coming down the pipe for an extended period of time, especially with government projections that the national debt will likely double once again in the next decade.

While everyone wants to call an end to the recession, the banking system is still being plagued by a high number of foreclosures and could be for some time.  While a number of homeowners took advantage lower mortgage rates this year to refinance into a more stable fixed rate mortgage, you still have quite a few people stuck in bad adjustable rate mortgages(ARM).

With rates as low as they are currently, there is little difference between the two mortgages rates.  Once the Federal Reserve stops buying mortgage securities those ARMs are likely see their rates shoot up putting them in danger of foreclosure.

The Fed still plans to buy approximately $700 billion more in mortgage securities of it’s planned $1.5 trillion, so mortgage rates should remain fairly sedate for the next year or so.  Most mortgage securities are still considered toxic assets and the banking system still really doesn’t know what to really do with them.

The Fed will likely be the major player in the mortgage securities market for some time and it will be awhile before private investors regain confidence in this market.  Mortgage securitization plays a vital role in credit system by helping banks rollover loans and extend more credit to other borrowers.

When mortgage security markets broke down that threw a big monkey wrench into the entire credit system and until foreclosure rates start to fall off the banks will have those toxic assets weighing them down.  The big banks will be fine no matter what, as the government will likely step in with a bailout as in the case of Bank of America and Citigroup.

However, smaller regional banks will be in for a tough time and the FDIC believes hundreds of them could fail in the next two years.