As secondary markets continue to walk on eggshells around Federal Reserve unpredictability regarding when it will begin tapering its quantitative-easing bond-buying program, analysts believe Treasurys will be the first on the chopping block.
The most popular market expectations put the central bank to begin tapering to start in September. However it’s not yet a done deal.
"But on balance, we think that the cumulative improvement in economic conditions since the Fed restarted its asset purchases last year justifies winding down the additional monetary stimulus," explained Capital Economics property economist Paul Diggle.
According to the latest Federal Reserve Bank of New York’s latest Primary Dealer Survey – used by the central bank as a gauge of market sentiment – a reduction in both Treasury and mortgage-backed securities purchases is what the market expects, Capital Economics explained in its latest market update.
However, Federal Reserve Bank of Boston president Eric Rosengren has spoken out in favor of running down Treasury purchases first and MBS second — or at least winding down MBS purchases at a slower pace — and analysts for Capital Economics agree with this approach.
"The Fed is concerned that Treasury purchases are inflating financial asset prices. It is far less worried about the stimulatory effect that MBS purchases are having on the housing market — especially given the recent spike in mortgage rates," Diggle stated.
He added, "Nevertheless, the additional beneficial impact on the housing market of running down MBS purchases more slowly than Treasurys would only be slight."
Frankly, the sums involved are relatively small.
Reducing both Treasury and MBS purchases simultaneously starting in September — the expected start of tapering its asset purchases — could put the Fed in purchasing $130 billion of MBS over that period. However, if the central bank were to taper Treasurys first and only once this was complete reduce MBS purchases, some $250 billion of MBS could be purchased over the same period, Capital Economics noted.
Overall, the incremental difference is only $75 million of MBS purchases, or 6% of the Fed’s current MBS holdings and 1% of all outstanding MBS.
Although the targeted buying of MBS seems to have a powerful impact on mortgage interest rates than Treasury purchases, the difference is relatively small.
"Some quick back-of-the-envelope calculations suggest that up until May when mortgage rates and bond yields began to rise rapidly on the back of fears that asset purchases would be tapered prematurely, each $100 billion of MBS purchases reduced 30-year mortgage rates by 0.06 percentage points," Diggle said.
He continued, "Meanwhile, each $100 billion of Treasury purchases increased mortgage rates by 0.01 percentage points."
In other words, the additional MBS purchases that the Fed would undertake by tapering MBS later than Treasurys are unlikely to have any significant effect on mortgage interest rates.
On the other hand, Royal Bank of Scotland (RBS) Markets & International Banking analyst Sarah Hu believes cutting MBS may have a greater direct impact on increasing mortgage rates than cutting Treasurys.
"How this will affect lending activity and housing recovery could become one of the factors in determining the priority," Hu stated.
However, the bottom line is that the housing recovery continues to be a bright spot for the economy and is one of the main successes of quantitative easing, analysts claim.
Moreover, market concerns about tapering have sent mortgage interest rates a full percentage point higher in recent months, making sense for the Fed to taper Treasury purchases more quickly than MBS purchases. More recently, mortgage rate are showing signs of stabilization and the Fed may not wish to disrupt the trend.
"But whichever strategy the Fed pursues, tapering is unlikely to derail the housing recovery," Diggle concluded.