Markets Await Tapering Strategy Following Unchanged QE3 Asset Purchases in July

by Julie Young
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Submitted by Quant Share. as part of our contributors program.

The Federal Reserve’s Federal Open Market Committee (FOMC) kept QE3 asset purchases unchanged in July. The FOMC’s strategic approach to aiding the economy since the height of the 2008 financial crisis has been focused on the Federal Reserve’s control of the money supply through open market operations. It has primarily used open market operations since 2008 when interest rates were reduced to near zero. While the Federal Reserve has a third option available, bank reserve requirement changes, this method has not been utilized.

In September 2012 the Fed announced its plans for QE3. This came after a window of 14 months following the end of QE2. September 2012 QE3 mortgage-backed securities (MBS) purchasing levels began at a rate of $40 billion per month with longer term treasury securities added in December 2012 at a rate of $45 billion per month. These purchasing levels have been in place since December 2012 with no change to asset purchases following the Federal Reserve’s July 2013 meeting.

The intention of the QE3 asset purchases is to help decrease longer term interest rates and specifically mortgage borrowing rates which has a targeted effect on the housing market. To achieve this effect the Federal Reserve has utilized the purchase of mortgage-backed securities in its quantitative easing approach in addition to its traditional open market treasury purchases. The purchase of mortgage-backed securities pushes prices up and longer term yields down. The purchases also help alleviate MBS risk from banks’ balance sheets which gives them greater lending capacity and capabilities.

Initial QE3 policy changes in September 2012 achieved the intended effect. From September 13, 2012 through June 13, 2013 30-year fixed mortgage rates remained at significantly lower levels than 2011 averaging 3.47% and dropping to 3.31% in November 2012, according to Freddie Mac’s Primary Mortgage Market Survey.

The focus of recent Federal Reserve communications has been on the June 19, 2013 meeting in which the Federal Reserve chairman, Ben Bernanke, discussed the FOMC’s intentions for tapering asset purchases. The Fed chairman stated the asset purchase tapering decision would be dependent on the economy’s progression toward the FOMC’s outlook.

For 2013, this outlook projects a 2.3%-2.6% change in GDP, a 7.2%-7.3% unemployment rate and core inflation of 1.2%-1.3%. The economy has progressed towards these levels since the last FOMC meeting. Second quarter 2013 GDP was revised up to 2.5%. The unemployment rate decreased slightly in August to 7.3% from 7.4% in July. In August the Bureau of Economic Analysis also reported a core inflation rate of 1.2%. This progression means the Federal Reserve is likely to begin tapering next week at its September FOMC meeting. Furthermore, the Fed chairman indicated in June that the QE3 tapering would last through mid-2014. As the September FOMC meeting approaches, speculators are beginning to consider a number of asset purchase tapering scenarios.

At an asset purchase rate of $85 billion per month, there are many scenarios the Fed could use for QE3 asset purchase tapering. It could reduce MBS purchases, reduce long-term treasury purchases, or make a simultaneous reduction of both security types. If you look at previous QE strategies, the Fed has outlined a total purchase amount with a specified end date. Consistent with this strategy, the Fed’s tapering announcement could likely include a total amount of purchases on a per month schedule with a specified QE3 ending date in mid-2014.

Regardless of the tapering strategy, the Fed has indicated that tapering is imminent and QE3 will likely end in mid-2014. The discussion of this tapering has shaken mortgage markets specifically and also caused some increased stock market volatility. According to Freddie Mac’s Primary Mortgage Market Survey, average 30-year fixed mortgage rates have increased from 3.91% at the beginning of June 2013 to 4.57% in the second week of September 2013, reaching a high of 4.58% during the August 22 week.

While the tapering discussion has impacted mortgage markets, with increased optimism partially helping the rate increases, it appears the reaction may be slightly overdone given the realization of the large increase in mortgage-backed and longer term treasury securities on the Fed’s balance sheet. While the Federal Reserve has announced it’s likely to finish its QE3 program in 2014 it has not announced any decision to sell any of its purchases and has also indicated it will continue with its principal reinvestment strategy.

Overall, the recovering housing market has been a key driver of economic growth for the economy and while the Fed has indicated an end to QE3 is near, the increased balance sheet holdings of MBS and long-term treasuries are expected to continue having the same market effect. This means mortgage rates could see another slight increase following the QE3 tapering announcement but are likely to plateau from there at significantly lower levels than the average weekly rate of 6.03% in 2008.

This article is provided on behalf of QuantShare. QuantShare is a trading software company that provides desktop trading software applications for serious stock, futures and Forex traders. Get your free trial here.

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