The Case for More Mortgage QE 

Kristina Hooper 

The Upshot 

8/26/2013 

Disappointing new home sales don’t mean that tapering is less likely to occur in September. Rather, they may only mean that when tapering begins, the Fed’s likely to start small and only trim Treasuries, says Kristina Hooper.
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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.

Mortgage Rates Matter


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.

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The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

 
Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities.


A Word About Risk
: Equities have tended to be volatile, involve risk to principal and, unlike bonds, do not offer a fixed rate of return. Foreign markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets.
 

Allianz Global Investors Distributors LLC, 1633 Broadway, New York NY, 10019-7585, us.allianzgi.com, 1-800-926-4456.

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