Quantitative Easing 101 (Part 3)

Quantitative Easing 101 (Part 3)
The bond markets are consumed with Quantitative Easing, so here’s a third primer on the topic (and here’s part 1 with a full timeline and part 2 with currency impacts). “Quantitative” refers to the fact that a specific quantity of money is being created; “easing” refers to reducing the pressure on banks. Many economists feel that the Fed’s next moves will reflate the US economy. But buying Treasury debt to push long term government bond yields lower will not directly transmit lower funding rates to any important parts of the economy (like mortgages or credit cards in the household sector). For mortgage bankers, the $1.25 trillion of buying of agency 30yr MBS’s was meant to lower mortgage rates for households, but only a small portion of the $11 trillion of household mortgage debt has been able to qualify and the rest remains around 6%. Analysts believe that we could see $1 trillion of additional Treasury purchases per year in addition to the roughly $400 billion in maturing MBS that will be replaced by Treasuries – but will it help the US consumer?

The Fed meets next week, and further moves are already priced into stock and bond market levels. As I mentioned recently, when the US government, who prints money, wants inflation, it is not a wise strategy to bet against them. The QE II (not the Queen Elizabeth II) that the press is consumed with is a form of government monetary policy used to increase the money supply, when necessary, by buying government securities or other securities from the market. This increases the money supply by giving financial institutions with capital in an effort to promote increased lending and liquidity. Quantitative easing appears when banks’ interest rates (overnight Fed Funds, discount rates, etc.) have already been lowered to near 0% levels and have failed to produce the desired effect. The major risk of quantitative easing is that although more money is floating around, there is still a fixed amount of goods for sale. And as we all know, with more cash and the same amount of goods, inflation usually increases, which in turn pushes rates (like mortgage rates) higher.

But currently, in our low inflation environment, low rates have not been enough to maintain an adequate money supply, and quantitative easing is employed to increase the amount of money in the financial system. The first step is for the central bank to create more money by crediting its own account (I wish I could do that!). This newly “created” money is then used for buying government bonds, or mortgage-backed securities, which in turn puts more money into the system. But a big drawback is that an increase in money supply to a country’s financial system has an inflationary effect by diluting the value of a unit of currency – and thus we see the dollar plunging.

Central banks are typically more concerned about faster inflation, but that certainly is not the issue now, and since overnight rates are near 0% and the purchase $1.7 trillion of securities has not had as much impact as they would have liked, next week the Fed will be discussing more purchases of Treasuries to flood markets with cheap money as well as strategies for raising inflation expectations to prevent stagnating prices from undermining the recovery.

For mortgage rates, however, no one is looking for much of a move one way or the other. “QE2 is already baked in the cake” as one economist put it. How and when the Fed will initiate new measures to stimulate the economy are good questions. Deflation is bad, a little inflation is good, and too much inflation is bad. Got it? Any increase in inflation is necessary in this environment but, any increase, or perceived increase, is not supportive to continued lower rates at the long end of the curve or mortgages.

Existing Home Sales Up, Disappointing Home Prices
Yesterday’s Treasury auction of $10 billion of 5-year inflation indexed notes was “ok”, but not great. On the plus side, the National Association of Realtors released Existing Home Sales data for September, showing an increase of 10% versus August. This number includes completed transactions that include single-family, townhomes, condominiums and co-ops. We are still about 19% below a year ago. $2.8 billion of MBS’s were sold and mortgages finished the day worse between .125-.250. (The 10-yr closed the day at 2.55 %.) Numerous investors had intra-day price changes. As one BofA trader wrote, “Higher equities, looming treasury auctions, and a large seller in futures space sent the rates market tumbling this afternoon. With the buyers finished for the day, mortgages were left vulnerable into lower prices.”

Today we’ve had the August home price valuations through S&P Case-Shiller. These August numbers were disappointing. Growth rates slowed or turned negative in several of the 20 markets monitored by the index. Later we’ll have Consumer Confidence for October, and a $35 billion 2-yr note auction. With that to chew on, stocks are pointing toward a down day, the 10-yr yield is sitting around 2.60% and mortgage prices are worse (again) .125-.250.