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Lending

The tapering of an era

Fed finally starts to curb QE3

Federal Reserve graphic

The announcement by the Federal Open Market Committee (FOMC) on Wednesday that it would be tapering both Treasurys and mortgage-backed securities (MBS) by $5 billion each defied conventional wisdom from most analysts.

Federal Reserve Chairman Ben Bernake said the Fed would cut the stimulus, adding that he expects the labor market will continue to improve and vowing that he and his successor, Janet Yellen, would keep interest rates low, adjusting the tapering as the committee sees fit.

The FOMC said that starting in January it will scale back its purchase of mortgage-backed securities to $35 billion per month from $40 billion per month – a 12.5% cut. The committee likewise will reduce its purchase of longer-term Treasury securities to $40 billion per month rather than $45 billion per month, an 11.1% cut.

The move marks the beginning of the end to what is the third round of quantitative easing, which began in September 2012. QE is a monetary policy implemented to prop up parts of the economy. Zero interest rates on Federal lending, part of the policy, will remain unchanged. By purchasing MBS and Treasurys, the Fed is able to create demand in those markets, thereby keeping liquidity intact.

Stocks surged on the unexpected news, with the Dow and the S&P 500 closing at record highs. The Dow surged 292.71 points, or 1.8%, to close at 16,167.97, well above its prior record close on Nov. 27. The S&P 500 jumped 29.65 points, or 1.7%, to finish the day at 1,810.65. The HW 30 — the HousingWire index of stocks impacting housing finance — rose 2.84%.

The decision to taper was not quite unanimous. Boston Fed President Eric Rosengren was the sole voice of dissent in a 9-1 vote, saying that he was concerned about the still high unemployment rate and the fact that inflation was still below the 2% target.

The decision came as the Fed slightly increased its overall economic forecast, Bernake said in a press conference. The Fed raised its expectations for growth in the gross domestic product (GDP) to a range of 2.9-3.2%, and said it expects a lower unemployment rate for 2014, with jobless claims falling to a range of 6.3-6.6%. Currently the rate is 7%.

Bernanke said Wednesday afternoon that the FOMC remains in full support of keeping rates low well beyond the time that the unemployment rate declines below 6.5 % line of demarcation, if and when rates reach that threshold. Another quantitative easing could come, he was careful to point out.

"We're not doing less. While we are slowing asset purchases a bit, we expect the total balance sheet to remain large,” the soon-to-be-retiring Fed Chairman said. “We expect to keep rates low for a very long time."

Sterne Agee chief economist Lindsey Piegza was quick to note this caveat, but believes that the Fed will stick to a plan of moderate reduction over the course of the next year barring any major changes.

"The Fed Chairman reiterated that tapering is not on a preset course and the pace of reductions could be increased or decreased depending on incoming data. The chairman further noted that if the economy was to slow markedly, the Fed could halt reductions from one meeting to another," Piegza said. “Bernanke noted, however, that his expectation for tapering is a moderate, constant reduction –$10 billion or so – going forward throughout most of 2014."

Other factors that support the decision for tapering include recent increase in GDP growth, and strong performance in the housing sector. There was a significant surge in housing starts for November  — up 22.7% from October, the highest level since 2007.

Jeff Taylor, managing partner of Digital Risk, an outsourced provider of mortgage services and risk analytics to the nation's largest banks and GSEs, said he expects that some of those housing gains will decline as a result of the tapering. He says interest rates will rise and home price appreciation will stall.

"Tapering mitigates a natural rise in interest rates that would normally be caused by aggressive government debt sales (T-Bills). As tapering is reduced, there will be upward pressure on interest rates; moreover, there has been some pressure during the last year, increasing the 10-year T-Bill yield by approximately 90 basis points. The 10-year treasury is now at 284 (basis points) and was at 161 (basis points) not long ago," Taylor said. "Expect at least a 25 (basis point) increase in rates, possibly 50 (basis point) increase by summer."

He also warned that the current house price increase will stall mortgage rates inevitable rise.  

"We expect a 25 basis point increase to raise monthly payment by approximately $30 per month or $360 per year; a 50 basis point increase will cause payment to rise by $720 per year," Taylor said. "As mortgage payments rise, the average consumer needs to pay more to own the same house.  This price increase will depress demand, causing housing prices to fall overall. An exception would be metropolitan areas with international demand such as New York City, San Francisco and Miami."

Some analysts had expected the Fed to start tapering back in September, but the looming partial federal shutdown and the threat of U.S. default, combined with a tepid jobs report for September, ensured there would be no tapering then.

Anthony B. Sanders, distinguished professor of real estate finance at George Mason University, said he believes the Fed was motivated more by fear of the damage the ongoing QE3 was causing than by any signs of strength in the economy.

"The Fed thinks that unemployment is falling fast enough so that they don't want to overstimulate the market. Of course, they focus on U3 (the current benchmark used for unemployment) and not competing measures like total unemployment or the labor force participation rate," Sanders said. "The real reason (for the tapering decision)? I think The Fed knows they are creating asset bubbles in the stock and housing markets, but don't want to admit it."

Many in the housing industry are worried what the tapering will do to housing demand.

"Following the Fed’s decision to begin tapering, Redfin is bracing for a shock to homebuyer demand," said Redfin economist Ellen Haberle. "Homebuyers aren’t going to be happy. In the weeks ahead, mortgage rates are likely to reach or exceed 5%, which will be a tough reality check for many homebuyers who have come to expect that rates start with threes and fours."

Still, tapering is a necessary step and it’s good it comes at a traditionally slow time for home sales, Haberle said.

"While painful, a taper in December could help buyers adjust to the higher rates and modify their budgets and neighborhood preferences while real estate is in its slow season so they can kick off their 2014 home search with grounded expectations," she said.

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