Kristina Hooper, CFP, CAIA, CIMA, ChFC, is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
The Fed’s big move this fall could be a tiny taper—one that doesn’t include spending less on mortgage-backed securities.
Investors seem to be holding on to hopes for the Fed to delay cutting back on its bond-buying binge a little longer. But a more likely scenario is a small paring of purchases in September that includes only government bonds. Why? Because buying mortgage-backed securities has given central bankers the most bang for their buck. Just look at the turnaround we’ve seen in housing after mortgage rates were pushed to historic lows.
The FOMC minutes show a Fed that’s more inclined to start tapering in September, although the move may be somewhat inconsistent with economic realities and potential threats to the recovery. The minutes show a Fed that continues to believe there are diminishing downside risks to the economy, despite recognizing that government cuts had a larger-than-expected impact on first-quarter spending. In terms of tightening financial conditions through rising rates, FOMC members seemed largely unconcerned. It appeared that the majority of FOMC members viewed higher rates as largely being offset by the rise in stock prices or looser lending standards. Some members also pointed to increased stability in the financial system as another offsetting factor. The prospect of tapering sooner rather than later clearly weighed on the stock market.
However, investors later cheered an ugly new-home sales number. The data, a 13.4% drop in July new-home sales, was far below expectations and adds a somewhat alarming post-script to the discussion on rising mortgage rates in the FOMC minutes. It refutes the observation that higher mortgage rates aren’t affecting the housing recovery and lends credence to fears some FOMC members have expressed that the housing recovery would be hurt by a rise in rates.
The Buzz from Jackson Hole
Fittingly, rising rates were a key topic at the Kansas City Fed’s annual Jackson Hole conference. Stanford economist Robert Hall warned that, “The central danger in the next two years is that the Fed will yield to intensifying pressure to raise interest rates and contract its portfolio well before the economy is back to normal.” But arguably the most critical paper released at Jackson Hole came from Arvind Krishnamurthy, who presented on the transmission of unconventional monetary policy. The most thought-provoking finding in his research was that purchases of mortgage-backed securities have been more impactful in lowering MBS yields than the purchase of Treasuries has been on lowering Treasury yields. In other words, MBS purchases are more focused, more effective and should continue.
If the Fed must taper, then it’s logical that it would want to cut back on the component of QE that has been least impactful, and that seems to be buying Treasuries. We’ve argued that this is a distinct possibility once tapering begins; it’s a position that has been advocated by a few FOMC members, including Eric Rosengren. And it may gain wider appeal on the heels of Krishnamurthy’s speech at Jackson Hole. In fact, the timing couldn’t be better given the slump in new home sales.
Looking ahead, we believe a careful reduction of asset purchases is clearly possible at the September Fed meeting, assuming the August labor report is broadly in line with the last few months. Still, MBS purchases could be left untouched. Stay tuned as we follow upcoming economic data, especially unemployment, in anticipation of the next FOMC meeting.
The Upshot is available as a subscription for financial professionals only. New issues will be delivered via email every Monday. Your email address must be in our records for your subscription to take effect.