Weekly Market Recap

Fed Minutes Give Hints to the Future

Last week, the Federal Open Market Committee (FOMC) released its minutes from the April 27^th meeting, giving some substance in the detail for the first time in a while related to “how they proceed from here”?  Some of the more interesting takeaways are as follows:

Most of the Federal Reserve officials stated that they prefer to raise benchmark interest rates before selling assets when the time comes to tighten policy.  During an extensive discussion of how the central bank might pull back its massive support for the world's largest economy, officials agreed they would eventual shrink the Fed's much expanded portfolio over the medium term, and that selling the mortgage related debt would be a priority.  "A majority of participants preferred that sales of agency securities come after the first increase in the (Fed's) target for short term interest rates," the Fed said.  And many of those participants also expressed a preference that the sales proceed “relatively gradually" the minutes stated.

The takeaway here is that when we see the first sign of a Fed Funds rate increase (projected Q1 or Q2 of 2012); this could be a precursor to exponentially higher rates in the mortgage sectors.  Historically, when Fed Funds increase, there is a very high correlation that mortgage rates will increase as well.  Couple with that the signal that the Fed will begin to sell its mortgage portfolio (more sellers than buyers = lower prices and higher yields), than there would be two compounding forces impacting interest rates.  But, again, the first Fed Fund increases are not anticipated until at least 1H12.

There are some dissenting thoughts to this action plan as well. Some economists are saying that right now, they don't see how the Fed would be able to off load their MBS holdings if they raise rates first, not without taking a substantial loss.  When the Fed is finally ready to start selling their MBS holdings, the market will have already pushed benchmark coupon yields above the MBS coupons owned by the Fed.  That means there would be limited incentive for investors to buy agency MBS because their yields would be below the yields (underperforming) offered by risk free benchmark Treasuries.  Therefore, the thought is that the Fed would likely be forced to hold onto a large portion of their MBS portfolio to avoid shocking the market and losing a hefty chunk of change.

However, we are a ways off from early 2012 and seeing how this actually plays out.  One thing is for certain, however: as the economy improves, interest rates, at some point in time, will increase given the forces detailed above.  For now, there is still time to capitalize on near historically low interest rates.

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