What Today’s (semi-surprising) Fed Statement Means for Mortgage Rates (Thanks Ben!)

by Alex Stenback on September 21, 2011

Today the Fed punctuated it’s two day conclave in the usual manner – by releasing a policy statement.

Though it was widely expected that the Fed would address the persistent economic weakness and add additional measures to bolster an obviously stalled-out economy, the exact nature and size of the initiative was a bit of an open question.

Operation “Twist”
Expected was a technically confusing (unless you are a bond geek) measure designed to lower long term interest rates. Dubbed “Operation Twist” the Fed would sell short term treasuries (causing those yields or rates to move up) and buy long term treasuries, forcing those yields/rates lower.

And Twist is what we got – the Fed will spend $400 Billion dollars by June of 2012.  The hope is this will provide additional support to the economy and speed a recovery.

But what we also got, was a surprising bit of Fed action aimed squarely at the Mortgage Market:

“To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. In addition, the Committee will maintain its existing policy of rolling over maturing Treasury securities at auction.”

In english: The Fed will buy more mortgage-backed bonds. It is the price of these bonds that, at length, determine interest rates.

So when the Fed steps-in as a buyer, mortgage bond prices rise, and mortgage rates fall.

In our view, this move was probably targeted to impact two things:

Refinances: Putting downward pressure on rates buys time for the powers that be to fix a largely dysfunctional system where in-the-money borrowers who should refinance cannot, because values have fallen too far and they lack equity.

I’d go so far as to say that for the Fed to step into the mortgage market this aggressively without an expansion of refinance rules from the FHFA will severely dilute any impact lower rates.

Correcting “Spreads”: The spread between mortgage rates and Treasury yields has been leaking wider in recent weeks. Mortgage rates were simply higher than they should be based on historical relationships with Treasury debt. This move, in part, was probably meant to address this and re-anchor spreads. No sense in driving down Treasury rates if mortgages don’t follow.

Bottom Line: The Fed has delivered a gift to mortgage seekers – how long it last, or whether the pot will be sweetened with additional expansion of refinance criteria for underwater homeowners, is anyone’s guess.

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