Fed to Slow Mortgage Purchases
The Federal Reserve today announced that they would slow their purchases of mortgages gradually over time. When the announcement was made, the market proceeded to fall for the remainder of the trading day, as can be seen below:
As most of you know, the stock markets, and the corporate bond markets as well, have been soaring for the past several months. During this time, the Fed has been buying about 80% of the entire U.S. mortgage-backed securities market (around $850 billion worth!). What happens when the Fed's purchasing of these securities slows? The Wall Street Journal has an article looking at just that question: When the Fed's Buying Ends
What happens after that program expires? The Fed has tentatively extended it by three months, to the end of March 2010.
Mortgage rates will likely move up, as private-market buyers will charge more than the Fed for bearing the risks of holding government-backed mortgage securities. As the Fed pulls back, Credit Suisse expects mortgage securities will yield about 1.15 percentage points more than 10-year Treasurys, compared with 0.9 percentage point now. Granted, that isn't a big increase, but there is huge uncertainty given how much of the market is dominated by the Fed. Any sustained upward move in mortgage yields could delay a housing recovery, given its shaky state.
Meanwhile, the Fed hasn't been buying corporate bonds, but its purchases of mortgages and Treasurys likely helped a blistering recovery in that market. Private investors were more likely to buy corporate debt than mortgages and Treasurys once Fed buying had made yields on those unattractively low. On a net basis, U.S. investment-grade companies will issue an estimated $820 billion of bonds this year, almost as much as in the previous three years combined, according to Barclays Capital.
A risk is that investors will be less attracted to corporate debt if mortgage yields go up as the Fed pulls back. Of course, the Fed could simply extend its asset purchases if private investors get the jitters again -- something it hinted at Wednesday, saying it will "evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets."
That is, if markets play along. Investors are already balking at the heavy use of printing presses. Just look at the sliding dollar.
As this article points out, investors may start to see more risk (I believe the risk has always been there, people may just start to see/realize it now) in the corporate bond market once the Fed is not pushing so much money into the mortgage-backed-securities market. I mentioned in my recent article, Market Sentiment Peaking?, that I would be watching the corporate bond market as a potential indicator that the market might turn around.
I will be keeping my eyes on the corporate bond markets to see when financing may start getting more difficult, and this may be a key sign of when the markets may have a turn towards the downside.
Corporate bonds generally rose today, but as the Fed begins to exit the markets, we may see more risk priced into corporate debt, which is something I will be watching for.
Disrupting the Housing Market
Bloomberg also reported today on the Fed's announcement in Fed Slows Mortgage Purchases, Sees Stronger Economy.
Sept. 23 (Bloomberg) -- The Federal Reserve will slow its purchases of mortgage securities, seeking to avoid disrupting the housing market as an economic recovery takes hold.
If the Fed is seeking to "avoid disrupting the housing market," then one might ask why were they so heavily involved in the housing market for this entire year? How is being 80% of the mortgage market not disruptive to the housing market? Does this even make any sense?
The central bank’s purchases and the Obama administration’s homebuyers’ tax credit helped stabilize housing and push the Standard and Poor’s Supercomposite Homebuilding Index up more than 30 percent this year.
Fed officials signaled a stronger commitment to support housing markets, saying they would buy “a total of” $1.25 trillion in mortgage-backed securities. Last month, they said they could buy “up to” that total.
This all seems "disruptive" to the housing market to me. Without these actions, mortgage rates would likely be higher (as the Wall Street Journal article mentions will probably be a result of the Fed's exit from the market), corporate bonds would likely have higher yields, and the U.S. Government would have less debt and less of a deficit.
All of these things would be good things. Mortgage rates need to be higher because the risk of default is higher. Default rates are soaring, and mortgage risk has definitely increased, why should rates go down in that environment? Corporate default risk is very high as well, and premiums for these corporations to borrow money should reflect that.
Of course, these things will come anyway. Mortgage rates will go higher, and I believe corporate bonds will also fall lower than their current levels. What the Fed is doing is delaying these inevitables, and this is a disruption of the market. There is no other way to look at it. As much as the Fed talks about avoiding "disruption," the very nature of everything they do is, in fact, disruption.
Sentiment
The Fed announcement today may have begun wearing away at the recent euphoria surrounding the markets, and articles such as the Wall Street Journal one above may help people realize what is going on. When sentiment does change, I think a significant pullback in corporate bonds as well as the stock market will be likely. This may cause another flight to safety, which could cause Treasuries to rise as well. It will be interesting to see how it plays out, but in the mean time let's see how long we can keep the party going.