Fed 8217 s Tapering Compostion amp MBS Implications

The reaction in currency and bond markets to the release of the minutes from last month’s FOMC meeting consisted of a higher US dollar, rising bond yields and non-directional volatility in equities. Interestingly, the reaction was opposite to FOMC statement from the same meeting 3 weeks earlier. Such contradiction has occurred more than once this year—Markets reacting differently to the FOMC minutes than they did to the release of the statement from the same meeting. The more direct explanation to such conflicted reactions is that the FOMC minutes contain more information than in the statement, which is more likely to sway markets in one direction than the shorter statement, which tends to be more balanced in language and limited in scope.

Tapering to Stay Away from MBS

While everyone is discussing the tapering—whether it will be announced and implemented in September, or announced in September and implemented later in the year—not much light has been shed over the composition of the tapering i.e. how much of the reduction will reduce the $45 bn in monthly purchases of long term treasuries and how much of it will trim the $40 bn in monthly purchases of agency mortgage-backed securities.

The consensus of estimates range between $15bn and $20bn in total tapering, to be evenly split between treasuries and MBS. As things stand, the Fed is likely to focus most or all of its tapering on treasuries, while allowing MBS mainly untouched. That is because the main objective of QE is to keep medium to long term bond yields underpinned to the extent of containing  mortgage rates and further supporting the housing market. This was the goal of the Operation Twist of focusing purchases on the long end of the curve.

The More Recent Poor Figures in Housing

US housing undoubtedly improved. New home sales hit 5-year highs, existing home sales reached 4-year highs and the S&P/Case-Shiller home price composite index of 20 cities is at 7-year highs. But as bond yields began their 4-month march to 2-year highs, short-term housing metrics fell hard. Most real-estate investment trusts are down 20% from their off their record highs reached in May. Refinancing of mortgages dropped 60% from their May high to reach their lowest levels since 2011. Such performance is not widely discussed in the media as housing-macro data occupy the headlines.

The reality remains that whatever taper amount the Fed will attain in autumn, it cannot afford to pull the plug off housing by tapering MBS. By supporting mortgages directly, the Fed could concentrate the bulk of its tapering in the treasury bond market. This way the central bank will appear responsible in reining in the QE bubble and responding to the notable improvements in labour markets. This may well allow 10-year yields to return gradually to 3.0% and 30-year yields to 4.0% without necessarily upsetting mortgages. By this definition, the Fed will have simultaneously tapered maintaining  accommodation in housing.