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Analysts tighten outlook for Fed exit from QE3

The announcement that the Federal Reserve will continue buying $85 billion of monthly assets came as no surprise to the market. And analysts expect little near-term change to the mortgage-backed securities market, which constitutes $40 billion of said purchase, ahead of the pending Easter Holiday.

To be clear, equity markets will be shut down Friday, March 29. The trade group SIFMA is asking for the bond markets to close early on Thursday, as well. In the time between now and then, a bevy of speeches from no less than five Fed officials are scheduled.

“All of the speeches are on the economy and/or monetary policy, so they will warrant attention,” according to a note from Deutsche Bank (DB) economist Carl Riccadonna, “and as long as their assessment of QE efficacy and economic conditions remains consistent, current policy accommodation will remain in place.”

On the other hand, the continued hints that the central bank will vary the size of its MBS purchases sooner rather than later provided incentive for Capital Economics to anticipate that the Fed will trim its monthly purchases sometime in the second half of this year.

“That doesn’t mean policy will be tightened shortly afterwards. After all, 13 of the 19 Fed officials don’t expect to raise interest rates until 2015, and we agree,” said Paul Dales, economist at Capital Economics in his latest report.

However, if the incoming economic news were to weaken again, the Fed would stick to its monthly asset purchases longer, even if not actually increase its purchases.

Moreover, some of the latest survey evidence suggests that activity in overseas markets has softened, which has left analysts at Capital Economics weary about the latest run of decent news on the U.S. economy.

“Our concern is that it may only be a matter of time before the recent weakness in overseas demand filters through into more subdued US activity, especially for manufacturers. That said, if the bulk of the improved tone of the economic news is due to a strengthening in domestic demand, then some slightly weaker news on the global economy shouldn’t matter too much,” the editor explained. 

Nonetheless, the housing recovery appears to be providing somewhat of a buffer against the bad economic news permeating from Europe. In fact, the domestic economy appears to be going from strength to strength and the recent acceleration in job growth has domestic forces at its roots too, the report noted.

“For the moment, the possibility that more of the recent strengthening in the incoming economic data is due to an improvement in domestic demand can only be a good thing,” Dales said. And if these continues to lead to more jobs, the Fed may look to exit quantitative easing sooner than expected.

For example, Deutsche’s Riccadonna said his team is projecting March payrolls to add more than 200,000 new workers.

“But if claims maintain their recent gains, payrolls should accelerate toward 250k+ in the coming months,” he said. “If this occurs, policymakers will feel compelled to reassess their stance and reduce accommodation.” 

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