Fed's debt foray aims to get mortgages moving

By Michael Mackenzie in New Published: March 20 2009 02:00 Last updated: March 20 2009 02:00 The US government bond market now has the ultimate buyer of last resort in the form of the Federal Reserve. The announcement of this $300bn move follows similar efforts by the Bank of England and Bank of Japan. The New York Federal Reserve will buy Treasuries on a regular basis for the next six months. The Fed slashed overnight borrowing rates to less than 0.25 per cent last year. On Tuesday, it announced it was increasing its purchases of mortgage debt to upwards of $1,250bn and would buy $300bn of government debt. This shows the Fed is intent on using its balance sheet to engineer substantially lower long-term rates. "The Fed knew that they had to get interest rates lower to stimulate consumer lending," says Bill Bellamy, director of fixed income at Thompson, Siegel & Walmsley. "The market didn't do it for them. In fact, the market went the other way over the last few months." The initial reaction shows that the Fed succeeded in surprising the bond market and that a large refinancing wave is poised to start. With house prices still falling and foreclosure rates rising, the Fed wants to get home loan interest rates down sharply. That will enable home owners to refinance at cheaper levels and ease their monthly mortgage payments. "The bond market was not priced for the news and at the end of the day the Fed achieved the desired policy affect," says Rick Klingman, managing director at BNP Paribas. "It remains to be seen how much lower rates fall." Yesterday, the yield on the 10-year Treasury note had backed up 6 basis points to 2.59 per cent, having been about 3 per cent early on Wednesday. Yields on five- and seven-year notes were 10bp higher after their huge drop on Wednesday. One factor concerning the market was highlighted yesterday when the Treasury announced it would sell $98bn in new two-, five- and seven-year notes next week. The new issuance dwarfs the Fed's likely $30bn in monthly Fed purchases. In order to match the Bank of England's proposed scale of gilts-buying, the Fed would have to buy more than $1,000bn of Treasuries, say economists. "Once the initial surprise wears off, the market tends to look past public relations moves in most cases," says Lou Crandall, economist at Wrightson Icap. "Ultimately, we think the market is likely to focus on the fact that the net market supply of intermediate and long-term Treasuries is still growing rapidly even after taking the Fed's buy-backs into account." Some bond traders are also questioning why the Fed has decided to buy Treasury debt, when recent speeches from central bank officials downplayed the likelihood of this happening. "There is a concern that the Fed knows something about the economy or perhaps they believe there will be less buying from the Chinese, so they have decided to push rates sharply lower," says John Spinello, strategist at Jefferies & Co. At the very least, with the Fed prepared to backstop the bond market, worries by foreign investors who hold more than half of the $6,600bn in outstanding Treasury debt should have eased, according to some analysts. "Global bond investors have to take some solace from the various expansions of quantitative easing, less debt and a buyer to backstop losses," says David Ader, strategist at RBS Greenwich Capital. In contrast, Jay Mueller, portfolio manager at Wells Fargo is worried about the signal being sent by the Fed to investors. "This is creating fiat money [irredeemable paper currency] to buy securities and in the long run, does nothing but devalue the dollar," says Mr Mueller. "I don't know how you can inject newly created money into the system without causing worries over inflation." The Fed is hoping that lower Treasury yields will also drag down other important interest rates for mortgages, corporate debt and loans. The Fed says it will concentrate on buying debt between two and 10 years. This suggests the central bank is looking to support bank debt of less than three years, which is backed by the Federal Deposit Insurance Corporation. Much of the Fed's Treasury purchase programme will target the intermediate area since the average life of 30-year fixed-rate mortgages is between five and 10 years. "The Fed will start their Treasury purchases in the seven- to 10-year area as it will help get mortgage rates down," says Ronti Pal, head of US rates trading at Barclays Capital. Driving down Treasury yields and accelerating purchases of mortgages should dramatically lower home loan rates and create a positive self-feeding cycle. As mortgage rates fall, so the need for mortgage portfolio managers to buy Treasuries as a hedge against the rising risk of prepayment will pull government bond yields lower. "The Fed's purchases of Treasuries will trigger another round of purchases from the mortgage community," says Mr Pal. Analysts expect the fall in mortgage rates will pull the average 30-year mortgage rate towards 4.5 per cent. Yesterday, Wells Fargo was quoting a fixed 30-year mortgage at 4.625 per cent, down from 4.875 per cent on Wednesday afternoon. "If 30-year mortgage rates continue falling towards 4.5 per cent, effectively the entire conventional mortgage market [currently at $5,500bn in size] will be refinanceable from a rate perspective," says Ted Wieseman, economist at Morgan Stanley. He says that "a potential refinancing wave approaching 90 per cent of that market would have potentially huge positive consequences for the housing market and consumer finances". Additional reporting by Nicole Bullock Copyright The Financial Times Limited 2009