As the unemployment rate slowly approaches the Federal Reserve’s (the Fed’s) stimulus-cutting target of 6.5%, we have to ask: is the stimulus working?

To answer this question, let’s first clearly define how the stimulus works. The Fed’s stimulus consists of:

  • purchasing a mix of mortgage-backed securities (MBS) and long-term Treasury securities; and
  • promising to keep short-term rates low until the jobs picture improves.

Their goal? Lower interest rates to stimulate spending (and business hiring), pulling the economy out of its protracted  recovery.

In case you hadn’t noticed, mortgage rates recently  spiked from around 3.3% in April 2013 to above 4.5% in June 2013. Mortgage rates have remained at this high level going into the fall.

How did mortgage rates jump the gun before the Fed began to taper their stimulus?

It all has to do with bond market confidence. The bond markets watch the Fed closely and respond quickly to their monetary policy changes. Bond trading affects Treasury yields, which mortgage lenders use to set their par rate.

As soon as the unemployment rate began to drop consistently, potentially signifying the Fed’s withdrawal, the bond market’s faltering confidence in the guarantee of continuing stimulus caused interest rates to jump. Thus, the Fed’s plan to keep interest rates low until the economy begins to regain some normalcy was thwarted by the so-called “rational market.” That market misread the Fed’s purpose and stated objectives.

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Not so fast! Unemployment numbers mislead the nation on housing

first tuesday insight

This summer’s rise in mortgage rates is a sign that investors are uncertain about Fed conduct. The uncertainty is due to the Fed’s opaque stimulus strategies.

The Fed’s Treasuries purchases are keeping short-term rates low, without much effect on employment. Further, their MBS purchases have proven insufficient to keep mortgage rates from spiking. Thus, a slow taper from Treasury buying and an increase in MBS purchases over the next year or more would likely bring the 30-year FRM rate back down to 3.5% — which is where it needs to be to get the housing market back on the road to recovery.

As much as it pains us to say, lenders need the easy money to keep the cash flowing to homebuyers for the very simple reason that  the Fed cannot lend directly.

If mortgage rates stay at their current level of around 4.5% (or rise), sales volume will be repressed in 2014. This condition prolongs our already lengthy recovery.

However, lower mortgage rates will mean:

  • improved sales volume for end users (not speculators, who primarily rely on cash to fuel their acquisitions but less so recently);
  • a boost for construction starts; and
  • an improved homeownership rate.

Related article:

Mortgage rates drive buyer purchasing power

Maybe with the top Fed Chair spot up for grabs in January 2014 (for which the potential contenders are down to a small handful), a new strategy will take shape.

Can we expect a dramatic change in the Fed’s modus operandi? Unlikely. But a shift from long-term treasuries back to MBS purchases is needed if mortgage rates are to keep the real estate recovery going.

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New York Times: Study Suggests Shift in Fed Bond-Buying

Re: Slackers at the Fed from the New York Times