Should The Fed Have Tapered?

At the last Fed meeting on Wednesday, September 18, the Fed elected to bypass the widely anticipated beginning of tapering its historical stimulus package. Following its decision to forego some sort of tapering, there was much consternation and hand wringing regarding the confusion the Fed created by not following the script the market had laid down for the Fed to follow. Apparently the Fed did not get the memo that it is supposed to do exactly what the majority on the Street anticipate. Many market participants claimed that the Fed misled them with its intentions and caught them off guard. Many are claiming that instead of creating more transparency with its post meeting briefings it is creating more confusion by being too open about their intentions. How exactly does that work? Many of these comments are laced with a certain amount of bitterness from being caught off guard by the Feds inaction.

Did The Fed Mislead The Street?

Leading up to the meeting it did seem that the Fed had indicated from its earlier meeting in June that it would indeed consider scaling back some of its stimulus possibly as early as its next meeting. Thus began the street's incessant forecasting of the timing and amount of the impending first taper. To go back and read the notes from the Fed meeting in June there is no specific reference to either the timing or amount of any such taper. So the Street created its own details of the initial taper and that became gospel to all of the financial news outlets including CNBC and Fox News. These two news outlets ran daily commentaries about the prospective tapering and therefore reinforced the notion of a taper at the September meeting and between $10 and $15 billion as the initial reduction of stimulus. Where did the Street get these amounts from? They are not written down anywhere in the Fed's minutes. The Street jumped to conclusions on tapering, placed trades accordingly, got it wrong and the trades went against them, and now it's upset. Perhaps the Street will learn a valuable lesson from this latest episode. Not to front run a Fed that is not sure itself what it is going to do from meeting to meeting.

Did The Fed Miss An Opportunity?

The question remains, did the Fed miss an opportunity to begin tapering? Most economists that have been interviewed believe that some sort of tapering is warranted as the benefits of stimulus have less apparent impact on the real economy and only serve to drive up values of risk assets. This is an interesting question. The logic for tapering at the September meeting was that the Street had presumably priced in a reduction of stimulus and markets would not be adversely affected. A side benefit was that the Street would interpret tapering as a vote of confidence by the Fed on the state of the economy. After the initial rally in markets, particularly equity markets, markets have since sold off. Hindsight is 20/20 and it is very difficult to say how the Street would have handled an actual taper and not the idea of a taper. It is fair to say however that given the markets behavior since the "non taper" it is hard to imagine the market behaving any worse. The Fed has indicated that it is leaving the door open to any and all options regarding its stimulus package. After reviewing the latest data it has determined that tapering back was not warranted. With this in mind it is hard to justify the Fed tapering at this time.

Are Historically Low Mortgage Rates Gone for Good?

First of all I would like to acknowledge those that lost their lives on September 11, 2001 and the loved ones they left behind.

Since July of this year as the 10-year treasury yield has climbed mortgage rates have followed suit. As mortgage rates are a function of the 10-year treasury yield, when treasury bonds sell off and their yield climbs mortgage rates typically climb as well. To contemplate why mortgage rates might come down in the future it is important to understand why they have moved higher in the present.

Why Have Treasury Bonds Sold Off?

Although the Federal Reserve controls short term interest rates it has little direct control over long term interest rates. The Federal Reserve raises and lowers the Federal Funds rate, the rate that banks lend to each other for overnight loans. Long term rates are a function of those short term rates plus a "premium" for tying funds up over a longer period. The plot of interest rates over time is known as the yield curve. The "normal" yield curve is upward sloping with long term interest rates higher than the short term rates. This curve reflects a healthy economy where future economic prospects are good and higher long term rates reflect the markets belief that the Fed will raise rates to control prospective inflation. However, on occasion the yield curve becomes inverted where short term rates are higher than long term rates. This yield curve typically indicates a weaker economy as economic prospects are dim. Current economic data points to an improving economy. Money managers and analysts suggest this as the reason long term interest rates are climbing. This may be one reason but it may not tell the whole story.

The speed at which rates have gone up suggests a stronger reason for the rise. The debate between popular analysts on TV whether rates can stay low for much longer is a reflection of money managers shifting funds away from fixed income to other asset classes, in many cases equities. As bonds are sold their yields rise. Bond price and yield have an inverse relationship. The opposite is also true. If bonds are purchased their price rises and their yields fall. So what would cause the sentiment among money managers and the general investing public to change regarding the outlook for bonds? If the economic outlook for the US and global economy were to deteriorate money managers will seek the safety of treasury bonds.

So What Direction Are Rates Likely To Go?

Depending on your outlook for the economy, you will either believe rates will stay elevated and keep rising or will fall back down to their historic lows. Most analysts suggest that rates are capped and will not rise much further and going forward may even fall back. The logic behind the cap is the historical spread between the Federal Funds rate and the 10-year treasury, which has never exceeded 400 basis points or 4.0%. Given the tepid economic growth both in the US and abroad it's hard to believe that rates will continue their rise. The traditional bond spread suggests a cap of 4.25% on the 10-year treasury and therefore a mortgage rate for a 30-year fixed rate loan of about 6.80% which is roughly 230 basis points above todays rate. The argument for rising rates is continued economic strength, which is unlikely. Current levels of unemployment and lower levels of consumer credit do not indicate an environment for greater economic acceleration. The argument for falling rates is weaker economic growth which is also unlikely. An improved real estate market and rising equities values continue to increase the wealth of average Americans. So where does that leave mortgage rates? Rates are probably range bound at this point. As the 10-year treasury yield trades between 2.50% and 3.00% mortgage rates will trade accordingly between 3.90% and 4.60%.

Will We Ever See Rates Back At Their Historic Lows?

For mortgage rates to fall back to their historic lows, the US economy would have to enter a recession, which is on the low end of probability. It is certainly possible. What is more realistic and probabilistic is that the economy slows from its current pace without entering recession and rates fall back close to their lows. This would actually qualify as almost catastrophic, not wanting to speak in hyperbole. The Federal Reserve would almost have to consider their efforts to rejuvenate the economy a failure after spending trillions of dollars with such low growth as a result.