February 19, 2010 — Amid signs of a still-firming economy, a technical move by the Federal Reserve caused a bit of ripple in markets this week, but potential borrowers should know that this has no direct effect on mortgage rates.
The overall average for 30-year fixed-rate mortgages tracked by HSH.com’s FRMI rose by five basis points (.05%), ending HSH.com’s survey week at 5.41%. The FRMI includes conforming, jumbo and the GSE’s “high-limit” conforming products in its calculation. The FRMI’s Hybrid 5/1 ARM counterpart moved a lone tick higher (.01%), during the latest survey cycle, landing at 4.58%. The all-important 30-year conforming fixed rate ticked just two basis points higher for the week.
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After the close of markets on Thursday, the Federal Reserve raised the Discount Rate by a quarter percentage point. This is the interest rate that a bank would be required to pay to borrow funds directly from the Fed itself, a move usually done only as a last resort when no funding can be obtained from other lenders in the market. The interest rate on such a loan is usually well above other market rates for similar funds; it’s often described as a ‘penalty’ rate.
Although the markets were caught a little off-guard, the Fed has been considering this move for weeks. Unfortunately, news that they were contemplating such a change didn’t become available until the Wednesday release of the January FOMC meeting. In the minutes it was noted:
[FOMC] Staff … suggested additional steps policymakers could take to normalize the Federal Reserve’s liquidity provision… These steps included… returning to the pre-crisis standard of one-day maturity for [discount window] loans to all but the smallest depository institutions; and increasing, initially to 50 basis points from 25 basis points, the spread between the [discount] rate and the [upper target for the Federal Funds Rate, presently 0.25%].
Among other things, the move was intended to discourage banks from coming to the Fed for money first, before trying to borrow funds in the open market, but the rate was raised only slightly so as to keep needed funds available at a still-low cost. Before the financial market crisis, the difference between the Discount and Fed Funds Rates was a full percentage point, so more moves can be expected before we approach ‘normal’. The small technical move’s effect on the market is minuscule, since only has recently only been about $15 billion in direct borrowing from the Fed, a pittance compared against the nearly $1 trillion in extraordinary liquidity the Fed pumped into the system over the past 18 months.
At the same time, the Fed also tightened up the terms of funds it makes available via its Term Auction Facility (TAF), a program designed to distribute funds to the market anonymously. That program comes to an end early next month.
Daily FRMI rates are available on HSH.com.
Check out our weekly Statistical Release here (and archives here).
The FOMC minutes also revealed a roadmap of sorts for future Fed policy moves. Once limited to changing the Federal Funds target rate and explicit discount rate, the excess reserves sloshing about the banking system will require new tools and policies to keep that cash from promoting unwanted inflation pressure. This means that the fine art of Fed watching will become more complicated, since market interest rate manipulations will now take several forms.
One of the Fed’s methods is paying interest on excess reserve funds which banks will park with the Fed. Presumably, a bank would do this instead of pushing it out into the market, and the Fed might make it attractive to do so. Excess funds are usually only parked on a short-term, often overnight, basis.
Another policy tool has the Fed taking cash from these institutions and replacing it with securities the Fed has in its portfolio. The Fed would “buy back” the securities at a later time, a process called a “reverse repo agreement”.
In the case where non-bank entities have huge holdings of cash, the Fed would conduct similar agreements, all in an effort to mop up excess cash.
The fourth way is similar to the first, except that the Fed hopes to institute a “term deposit facility,” a kind of CD for banks. In this fashion the Fed might offer attractive rates for a bank to park excess funds for three or six months, and would give the Fed a way to keep pools of cash on its books for measured periods of time so that they would be released into the broader economy on a more measured basis. The Fed noted that a TDF could be operational “as soon as May.”
The fifth method would see the Fed holding onto cash as its holdings of Treasury securities and other investments mature. Rather than reinvesting the proceeds, the Fed would simply accumulate a cash pile in place of a pile of securities. This would also mop up cash, although on a slower and longer-term basis.
And finally, the Fed could sell outright the securities they have in portfolio.
It is expected that a variety of manipulations — individually or in conjunction with others — will be employed to both reduce the size of excess reserves in the system and make material changes to market interest rates. Ultimately, though, the Fed expressed a preference for the old tried-and-true method of adjusting interest rates:
With respect to longer-run approaches [the Fed] saw benefits in continuing to use the federal funds rate as the operating target for implementing monetary policy, so long as other money market rates remained closely linked to the federal funds rate.
The minutes went on to say that Fed may end up with a three-tier system: the Federal Funds target rate, the Interest on Excess Reserves rate, and the Discount Rate.
A last note of import was the discussion of how to shrink the Fed’s bloated portfolio of MBS and other holdings. A return to only traditional holdings of US Treasury debt is expected over time, but there is no plan to dump other holdings onto the market; they’ll simply not be replaced as they mature or are refinanced. This includes hundreds of billions in debt issued by Fannie and Freddie as well as the $1.25 trillion in MBS the Fed now holds.
All this comes in the context of a gently firming economy. The stronger that economic growth becomes, the more need and urgency there will be to drain all the emergency liquidity from the markets before an inflation problem can foment. Hopefully, other central banks around the world will begin to implement similar policies. In the meanwhile, they are largely lifting interest rates modestly.
The economic recovery is continuing, if not starting to expand modestly. So far, it has been a recovery which we have deemed “technical” since it has largely been led by an inventory rebuilding cycle which came after perhaps an unprecedented slashing of stockpiles and has to date not included hiring or a more dynamic consumer. The latest reviews of regional manufacturing activity point to continued growth, with both the New York and Philadelphia Fed’s local indices gaining strength in February. In both cases production activity expanded, and even hiring plans showed a bit of firmer footing. We’re not at the end of the inventory-rebuilding process just yet, but if final consumer demand doesn’t begin to show before long, it would be logical to expect a return to a shallower trajectory for production.
The measure of Industrial Production moved strongly higher in January, gaining 0.9% as signs of expansion were evident in all facets of the report. The percentage of factory floors actively in use continues to slowly rise, but at only 72.6% remains a long long way from the levels which promote inflation-inducing bottlenecks in production. The increase here has followed the upturn in the index of Leading Economic Indicators, which continues to point to positive markets conditions. In January, LEI moved 0.3% higher, rather less than the moves noted in recent months but still heading in the right direction, if less so. LEI purports to be a forecasting tool for the economy some six months down the road but probably better reflects the more immediate climate.
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Sources: FRB, OTS, HSH Associates.
Although broadly rising prices aren’t yet a concern, costs do appear to be moving back upward after a fairly protracted period of regular declines during the recession. Prices of imported goods rose by a stout 1.4% in January as petroleum costs boosted the lift beyond forecasts. The sizable 11.5% increase in import prices relative to last year isn’t surprising, given that costs were declining at the time. Last month, the US exported a little more inflation, too, with goods priced for export lifting by 0.8% for the period, causing a cumulative 3.4% lift over the last 12 months.
With inbound costs increasing and especially goosed by rising fuel costs, the Producer Price Index leapt 1.4% in January, about double the expected increase. However, absent petroleum products the rise was a much more muted 0.3% for the month. Over the last year, headline PPI has now risen by a full 5%, but the ‘core’ PPI has risen just 1%.
Downstream of producers reside consumers. As not all rising price inputs upstream make it all the way to the end user’s pocketbook, the Consumer Price Index notched just a 0.2% lift for January. The ‘core’ CPI actually declined by 0.1% for the month, so the little bump in costs was all caused by food and energy prices firming during the period.
A place where some inflation might be welcomed (at least by homeowners) would be in home prices, which are still suffering from deflation. The way to produce this is to increase demand, and the combination of low interest rates and tax credits is providing some important supports for the market. Still, final demand is weak enough and inventory of unsold home plentiful enough as to have little need to build new stock, at least in the present market. Housing Starts did manage to nudge higher in January, recovering some of the December dip caused by the on-again-off-again-on-again nature of the homebuyer tax credit. Starts improved to a 591,000 level, up from about 575K in December, but have remained in a narrow range since last June. Building Permits, a measure of activity yet to come, slid by 4.9% to an expected 621,000 units to be built over the next year.
Still, the little boost in starts was sufficient to prompt an improvement in the sentiment of members of the National Association of Home Builders. The trade group’s index of market conditions rose to 17 in February, a bump of two points. While not enough to break it out of its still-weak level, improvements in single-family sales and six month outlooks suggest that the worst of the market for builders is slowly fading behind up. As we noted last week, we think there is a good likelihood that the homebuyer tax credit will be extended, and that market mechanisms now in place will probably serve to keep interest rates favorable for the important spring homebuying season.
Consumer moods, as related by the ABC News/Washington Post poll of Consumer Comfort, continue to hold at pretty bleak levels. The -49 figure for the weekly survey of February 14 is closer to recent bottoms than recent high points, but is pretty much steady. The cessation of broad layoffs in the economy over the last few months has seen halted regular declines, but improvement probably won’t be seen here until hiring gets underway. During the week ending February 13, some 473,000 new application for unemployment assistance were filed, a 31,000 increase from what seems to have been a winter-storm distorted 442,000 the week prior. We have been expecting the average level of new claims to have settled around 450,000 or so as part of a slow decline, but the weekly numbers have been distorted for a number of reasons since the beginning of the year so it’s difficult to tell if much progress is being made on the labor front.
As we expected, mortgage rates put in a little increase this week. Next week, it’s all about housing, as we’ll get a look at Home Prices, New and Existing Home Sales, durable goods orders and a few other interesting bit of market data. Given the drift higher in Treasury yields last week and again this week, we think it’s a fair bet that we’ll see a little bit more of an increase in mortgage rates again next week, probably another few basis points or so.
It’s never too late to look ahead. If you’ve got a couple of minutes, you should check out our 2010 Outlook for Mortgage Markets and Rates. It covers what we think are the ten most important considerations for the market this year.
Our latest two-month forecast offers our predictions for the immediate future.
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