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A nagging question about the healing now taking place in banking and the markets is what happens when the government starts withdrawing the financial medications that saved the economy?
Because the Federal Reserve and the U.S. Treasury are administering an unprecedented cocktail of loans, guarantees and purchases of assorted securities, the weaning process will likely produce more than a few unpredictable shudders. This won’t be as simple a matter as in past recoveries when the question was whether the Fed’s next move amid a reviving economy would be to raise short-term interest rates by one quarter of a percentage point or two.
A glimpse of the potential complications surfaced recently in the markets for mortgage-backed securities. The Fed has been fairly steadily buying $25 billion of MBS every week this year to rekindle that market, support house prices and provide capital to refinance mortgages at lower rates for consumers and the economy. The Fed has also been buying Treasuries, the yields of which are benchmarks for mortgage rates. The buying so far has been “decisive” in bringing down interest rates and avoiding a depression, says James Swanson, chief investment strategist at MFS Investment Management. He says the buying will save mortgage holders about $135 billion in interest payments this year alone because effective mortgage rates have dropped to 5% from about 6.2% in 2008. “It is clear from what we’ve seen that the government intervention in the mortgage and Treasury markets will keep mortgage rates low enough that the housing market can recover,” says Swanson. In fact, until house prices firm up for a four-month stretch, Swanson expects the Fed and Treasury will continue with what he calls a “bizarre” and “dramatic” campaign to control the price of long-term money in one of the world’s biggest markets.
The Fed said in March that it would buy up to $1.25 trillion of MBS by year-end. That works out to about $25 billion a week. Despite the steady buying, in recent weeks mortgage rates have gone up, which was lamented by Fed Chairman Ben Bernanke Tuesday in testimony to Congress. Bernanke said the reasons for the rise include concerns about large federal deficits, greater optimism about the economy, some flow-back toward riskier securities and what he called “technical factors” in the mortgage market.
In fact, the MBS market has become more volatile recently as investors have tried to anticipate the price impact from the Fed’s moves to influence MBS trading, credit market strategists at J.P. Morgan wrote over the weekend. The result, the strategists wrote, is that the market “will have to price in greater volatility in their assumptions going forward.” That means mortgage money will have to cost a little more than if the MBS market were trading normally without the Fed’s involvement. The volatility could increase again late in the summer and early in the fall as MBS investors try to anticipate the Fed’s final moves in winding down the support program. As early as October, according to the strategists, you could see a glimpse of how the market thinks mortgages will be priced in January.
You might think of it all as a bizarre square-dance, one where a lot of dancers are trying to take the next step before it is announced by a caller, a caller who just happens to be on the floor and appropriately nick-named Big Foot. Somebody’s going to get stepped on.