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Yes, Quantitative Easing Helps Mortgage Rates, but There's a Catch
TwornFederal Reserve System economists have looked at the recent quantitative easing</bprograms of the Federal Reserve to determine whether a central bank's monetaryrnpolicy could retain potency when short-term rates reach zero. The two, Diana Hancock and Wayne Passmore, wererntesting their theory that because the banks could purchase a wide variety ofrnassets, not just short-term government securities the purchases could be used tornenforce explicit ceilings for yields on longer-term securities, including longer-datedrnTreasury securities, agency debt, or agency mortgage-backed securities </p
If such a long-term asset purchase program werernsuccessful they say, not only would yields on such securities fall, but yieldsrnon private debt (such as mortgages) would probably fall as well and thernincrease in the monetary base would lead to an increase in asset prices inrngeneral and a subsequent impact on spending. rnThus, even a central bank whose accustomed policy rate has been forced downrnto zero would not “run out of ammunition.” </p
Torntest these assumptions they two looked at the impact the Fed’s large-sale assetrnpurchases (LSAPs) or quantitative easing (QE) programs had on agencyrnmortgage-backed security (MBS) yields and thus on conforming mortgage interestrnrates. They selected periods when thernfinancial markets were functioning well rather than being in turmoil becausernthe prevailing view is that LSAP’s would have no effects on asset prices inrnnormal times. They tested the countervailingrnopinion is that such purchases can potentially influence all components of MBSrnyields to some extent by (1) signaling Federal Reserve intentions to financial marketsrn(2) portfolio rebalancing effects, and (3) liquidity effects. </p
Thernpurchase of long-term assets may make more credible the Feds commitment to keeprninterest rates low even after the economy recovers, particularly if the centralrnbank weighs potential losses on its asset holdings in its objective function. This signaling affects all bond market interestrnrates, since lower future federal funds rates can be expected to affect allrninterest rates. And, as market participantsrnanticipate the announcement of LSAPs, their effects can be reflected in market pricesrneven before they are announced.</p
Thesernpurchases can also potentially affect MBS yields through a portfolio rebalancing</bchannel where the Fed purchases reduce private sector holdings while increasingrnshort-term, risk-free, private sector bank deposits. Thernprivate sector finds it holds more of these deposits than they desire becausernof receipts from selling securities so they bid up prices of remainingrnlong-term securities and thus lower the yields. rnThis "scarcity" effect is primarily focused on the current coupon yieldrnMBS. </p
Forrnlonger-term securities, this portfolio rebalancing effect is often expectedrnfrom duration and convexity risk. Duration refers to the length of time that the bonds will likely provide an income stream. Convexity refers to “duration’s sensitivity to rates”–i.e. a pool of mortgages that might normally last for about 7 years could quickly change to lasting half that time if rates fall quickly enough, prompting more refinances out ofrn that pool. </p
When MBSrnare withdrawn from the market the private sector finds they must meet their demandsrnfor duration and convexity by bidding more aggressively for MBS. The portfolio rebalancingrnin this case has two components: (1) a willingnessrnto take less compensation for hedging the interest rate risks of financialrnassets, or a “duration effect,” that applies to both Treasury securities and MBS;rnand (2) a willingness to take less compensation for hedging the prepayment and volatilityrnrisks that are associated with holding MBS, i.e. a “convexity effect.” When purchasingrnTreasury securities, the Federal Reserve was quite aware of the duration effectrnand specifically targeted its purchases of Treasury securities toward those withrna maturity of 4 to 7 years, so that it would withdraw more duration from the market. MBS typically have a duration that is in thern4 to 7 year range.</p
Atrnthe same time, LSAPs by the Federal Reserve could potentially operate through arnliquidity channel. Investors are willing to pay a premium for a securityrnthat remains liquid when other securities do not or when market returns overallrnare low. The effect of Federal Reserve asset purchases on liquidity is unclear.rn They may increase the liquidity in the future,rnparticularly during “bad” markets, because of a belief that the Fed will remainrna large and persistent buyer in those markets. rnOn the other hand, as the Fed’s holdings of a security increases during “normal”rntimes, the private sector holdings of the security may diminish, leading to a thinnerrnmarket in the future with fewer seller opportunities. Withdrawal of securities from the private sectorrnby the Fed might diminish future liquidity if there is uncertainty about thernFed buying in a bad market of the future. </p
LSAPsrncan change the expectations held by market participants about future interest ratesrnbecause they communicate the intentions of the Federal Reserve. However, information about the effects of newrnquantitative easing programs, or about long-term asset purchases, is often learnedrnover time; consequently asset prices may adjust more slowly. Moreover, the liquidity effects associated withrnasset purchase programs may be difficult to understand, or to predict, at therntime when asset purchase programs are announced. Finally, investors anticipate both the announcementsrnand the effects of LSAP programs, which may lead to underestimating the effectrnof a given announcement. </p
Thernauthors conclude that assessing the effects of the Federal Reserve’s openrnmarket operations is difficult because of the way monetary policy accommodationrnoperates through so many transmission channels.</p
Therndecline in the MBS yields after the initial announcement of a large-scale assetrnprogram may generally reflect a shift of market expectations, but may not fullyrncapture the actual effects of the large-scale security purchases as portfolio rebalancingrnactually commences. They found that thernFed’s market share variables were significant determinants of MBS yields, even afterrnaccounting for changes in expectations about future rates by market participants.</p
Theyrnsay their estimates also suggest that the Federal Reserve must hold a substantialrnmarket share of agency MBS or of Treasury securities to significantly lower MBSrnyields and in turn significantly lower mortgage rates. The liquidity or portfolio rebalancing effectsrnof LSAPs, as well as markets’ expectations of future interest rates, arernimportant considerations for monetary policy. rnFinally, their findings suggest that such LSAPs achieved the Open MarketrnCommittee’s goal to “put downward pressure on longer-term interest rates, supportrnmortgage markets, and help make broader financial conditions more accommodative.”
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Steven A Feinberg (@CPAsteve) of Appletree Business Services LLC, is a PASBA member accountant located in Londonderry, New Hampshire.
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