I explained why this strategy keeps rates low when they announced it in September. Read it here.

The Fed didn’t confirm rumors about QE3 focused on buying more mortgage bonds in Q12011.

Mortgage bonds (FNMA 3.5% coupon) were down as much as 23 basis points to start the day, but rebounded sharply and now up 34 basis points. Rates drop when bond prices rise like this, and vice versa.

The rally came after a very strong $21b auction of 10yr Notes which had the second highest ever bid-to-cover ratio (a measure of demand) of 3.53.

The week’s busy economic calendar continues with Import/Export prices tomorrow, and jobless claims, inflation and manufacturing data on Thursday and Friday.

December 13 Fed Statement (Last 2011 FOMC Meeting)

Information received since the Federal Open Market Committee met in November suggests that the economy has been expanding moderately, notwithstanding some apparent slowing in global growth. While indicators point to some improvement in overall labor market conditions, the unemployment rate remains elevated. Household spending has continued to advance, but business fixed investment appears to be increasing less rapidly and the housing sector remains depressed. Inflation has moderated since earlier in the year, and longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.

The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools to promote a stronger economic recovery in a context of price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action was Charles L. Evans, who supported additional policy accommodation at this time.

This is the latest in a cycle of Washington-led uncertainty. Stocks and bonds are swinging wildly since the FOMC announcement, and it’s still questionable if/when lenders will issue rate improvements because mortgage bonds are all over the map: FNMA 4% coupon was -12 basis points before FOMC, then +113bps, then down to +25bps, and now hovering in +88bps range. When bonds are up like this, yields (or rates) drop, but again, lenders are holding the line while the volatility plays a bit further. Here’s the Fed statement…

FOMC STATEMENT 8/9
Information received since the Federal Open Market Committee met in June indicates that economic growth so far this year has been considerably slower than the Committee had expected. Indicators suggest a deterioration in overall labor market conditions in recent months, and the unemployment rate has moved up. Household spending has flattened out, investment in nonresidential structures is still weak, and the housing sector remains depressed. However, business investment in equipment and software continues to expand. Temporary factors, including the damping effect of higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan, appear to account for only some of the recent weakness in economic activity. Inflation picked up earlier in the year, mainly reflecting higher prices for some commodities and imported goods, as well as the supply chain disruptions. More recently, inflation has moderated as prices of energy and some commodities have declined from their earlier peaks. Longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting and anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, downside risks to the economic outlook have increased. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate as the effects of past energy and other commodity price increases dissipate further. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.

To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent. The Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.

The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen.

Voting against the action were: Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, who would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an extended period.

All voting FOMC members voted for this policy stance. Throughout 2010, Kansas City Fed president Thomas Hoenig was the lone dissenter (and still is) on this zero-rate policy stance but now that he’s rotated off the FOMC, nobody else is bringing balance to the zero-rate stance. It’s not that the Fed is outright ignoring inflation, but it just means they’re not communicating clearly about it, which will mean a much bigger jolt to markets (especially rates) when they begin to telegraph the end of this zero-rate stance by saying they’ll sell bonds and/or hike overnight rates. Consumers should strongly consider grabbing low rates while they can, because these rates aren’t going to last for as long as people think. TODAY’S CASE IN POINT: rates were .2% better this morning before the Fed announcement and reversed completely as mortgage bonds have sold drastically since the announcement acknowledged inflation pressure. It’ll only take a small bit of inflation for rate markets to reverse more, and the latest inflation data comes out tomorrow (PPI business inflation) and Thursday (CPI consumer inflation). Today’s full Fed statement is below. It doesn’t address anything about Japan, Europe, or the Middle East, which are three main drivers of rate market trading currently, but dire situations in all three of these regions are actually helping the Fed’s low rate case right now.

FULL 3/15/11 FOMC STATEMENT
Information received since the Federal Open Market Committee met in January suggests that the economic recovery is on a firmer footing, and overall conditions in the labor market appear to be improving gradually. Household spending and business investment in equipment and software continue to expand. However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed. Commodity prices have risen significantly since the summer, and concerns about global supplies of crude oil have contributed to a sharp run-up in oil prices in recent weeks. Nonetheless, longer-term inflation expectations have remained stable, and measures of underlying inflation have been subdued.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate remains elevated, and measures of underlying inflation continue to be somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. The recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation. The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations. The Committee continues to anticipate a gradual return to higher levels of resource utilization in a context of price stability.

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November. In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.

The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen.

All FOMC members voted for today’s policy action, and Kansas City Fed president Thomas Hoenig the lone dissenter at every FOMC meeting of 2010 was not on the FOMC for 2011 because he’s rotated out. He believes strongly that the Fed needs to ease off of QE2 and raise overnight rates. But this first meeting of 2011 initially shows everyone is in agreement, which isn’t necessarily good for policy setting. But we’ll find out if there’s an actual debate when the full minutes of this meeting are released next month.

FULL FOMC STATEMENT
Information received since the Federal Open Market Committee met in December confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring about a significant improvement in labor market conditions. Growth in household spending picked up late last year, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, while investment in nonresidential structures is still weak. Employers remain reluctant to add to payrolls. The housing sector continues to be depressed. Although commodity prices have risen, longer-term inflation expectations have remained stable, and measures of underlying inflation have been trending downward.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November. In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.

The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

Of all items in the statement, Hoenig’s position (that 0-0.25% overnight rates and ongoing Quantitative Easing is inflationary) is perhaps the most worrisome to bond markets because inflation erodes buying power of a bond’s future cash flows. Hoenig was the only FOMC member to vote against such accommodative rate policy, keeping his streak of dissenting at every 2010 meeting.

FULL FOMC DEC 14 STATEMENT
Information received since the Federal Open Market Committee met in November confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment. Household spending is increasing at a moderate pace, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. The housing sector continues to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have continued to trend downward.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.

The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Sarah Bloom Raskin; Eric S. Rosengren; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

Voting against the policy was Thomas M. Hoenig. In light of the improving economy, Mr. Hoenig was concerned that a continued high level of monetary accommodation would increase the risks of future economic and financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy.

The Fed’s low rate and quantitative easing policies are designed to prevent deflation and stimulate growth to the point of seeing inflation, at which point they’d reverse these stimulative policies. For now, mortgage bonds are swinging rather wildly between gains from early today to par. Until trading plays out for today, rates are still holding near record lows. The full Fed statement is below.

Full November 3 FOMC Statement
Information received since the Federal Open Market Committee met in September confirms that the pace of recovery in output and employment continues to be slow. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts continue to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.

The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Sarah Bloom Raskin; Eric S. Rosengren; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

Voting against the policy was Thomas M. Hoenig. Mr. Hoenig believed the risks of additional securities purchases outweighed the benefits. Mr. Hoenig also was concerned that this continued high level of monetary accommodation increased the risks of future financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy.

57 Failed Banks YTD
It’s Monday, so that means I get to write about the FDIC closing down banks. (We’re up to 57 this year compared to 140 for all of 2009.) In this case Illinois got whacked with seven banks from that state eliminated, with their mugs and t-shirts becoming collector’s items. The FDIC took over four banks in Chicago: New Century Bank, Citizens Bank & Trust, Broadway Bank, and Lincoln Park Savings. And just so the rest of the state didn’t feel left out, Amcore Bank (Rockford, IL), Peotone Bank and Trust Company (Peotone, IL), and Wheatland Bank (Naperville, IL) were shut down. MB Financial Bank agreed to acquire the deposits of both Broadway and New Century, Republic Bank (IL) assumed Citizens’ deposits, and Harris National Association (IL) agreed to acquire Amcore Bank’s deposits. Northbrook Bank and Trust Company took Lincoln Park Savings’ deposits; First Midwest Bank of Itasca agreed to assume Peotone Bank and Trust’s, while Wheaton Bank & Trust will acquire the deposits of Wheatland Bank.

FHA & VA Loans Going Strong
Recent statistics are showing continued strength in FHA and VA production volumes. Maybe not Streamline Refinances, but for purchases and non-streamline refi’s. With the reduction of lenders offering subprime loans at decent rates, the reliance on FHA/VA loans is now easily exceeding the experience of the 1990s or early-2000s. Any agent will tell you that there are currently only three options for borrowers: Very clean and well documented non-agency borrowing with low LTV’s, clean GSE loans with FICO’s well above 700 and LTV’s generally less than 80%, and FHA & VA often as a choice of last resort. Yes, everyone is excited about the Redwood/Citi deal coming to the market, but we have a ways to go until non-agency securities are welcomed by investors and non-portfolio lenders.

Mortgage Insurance Company Earnings
Wall Street has been pleased with the earnings of the MI companies, although cynics would say that they are still losing money. MGIC lost $150 million in the first quarter versus a loss of $185 million a year ago. RMIC had a net income of $25 million last quarter versus a loss of $54 million for the same period last year. And PMI lost $649 million for all of 2009 versus a loss in 2008 of $929 million.

Parsing The FOMC Statement
Do you think that, years from now, we’ll be telling our grandkids how analysts and traders would analyze every word of the Fed statement that was produced after they met just to look for microscopic clues on the markets? And how prehistoric that seems? This week we’ll hear from the Fed, and most expect that the Fed is seeing the same thing many are: slow but sustained economic growth, lagging consumer spending, tight credit, a muddling housing market, and little sign of inflation. The committee will likely conclude that conditions continue to warrant leaving rates “exceptionally low” for an “extended period.”

More on +27% New Home Sales
New Home Sales were up 26.9% in March. Granted, February was a pretty light number, but still it appears that the business is seeing yet another wave of folks taking advantage of the tax credits that won’t exist after this week. The South and Northeast posted the strongest gains, with sales in the South rising 43.5% in March, 35.7% in the Northeast, 4.3% in the Midwest and 5.7% in the West. March’s new home sales figure is up 23.8% from a year earlier even though new home sales growth has been sluggish. In March, the median price (half below, half above) for a new home increased 4.3% on a year-over-year basis to $214,000. In looking at home sales sorted by price, in the first quarter 45% of new home sales were below $200,000, while only 13% were above $400k. That certainly helps the argument that FHA/VA, Fannie/Freddie will dominate for most, if not all, of 2010 and possibly beyond.

Who’s Buying Mortgage Bonds?
Which entities were buying mortgages Friday, without the Fed? Asian investors, banks, hedge funds, and money managers were all reported to be in sniffing around. And originators were happy to oblige by selling an estimated $1.5 billion to them. And with a lot of Treasury supply coming in most every week, there’s a school of thought that suggests that investors buy mortgages rather than Treasuries. The mortgages being originated now are cleaner, better documented, and of better quality than in the last several years. Besides, with the Fed keeping short term rates near 0%, funds can earn 1% in 2-yr USTs, 2.5% in 5-yr Treasury notes… why not pick up a little yield by earning 5.25% on some 60% LTV full doc loan?

Economic Preview For Week
Greece actually requesting financial help, along with that solid New Home Sales figure and the thought of more auctions this week pushed rates higher on Friday. (One can argue that no one knows exactly what moves markets, but it was easiest to blame those factors.) This week presents us a mixed-bag of economic releases, on top of the auction. Today we have Building Permits. Tomorrow we have the S&P/Case-Shiller Price Index, along with Consumer Confidence. Wednesday is the Fed meeting mentioned above, Thursday is Initial Claims and the Chicago Fed numbers, and on the last day of April we have the GDP numbers, the Employment Cost Index, and Chicago Purchasing Managers’ numbers. Currently the 10-yr yield is 3.80% and the 5-yr Treasury and mortgage prices are both better by about .125.

Daily Humor
The local news station was interviewing an 80 year old lady, because she had just gotten married for the fourth time. The interviewer asked her questions about her life, about what it felt like to be marrying again at 80 and then about her new husband’s occupation!

“He’s a funeral director,” she answered.

“Interesting,” the newsman thought. He then asked her if she wouldn’t mind telling him a little about her first three husbands and what they did for a living.

She paused for a few moments, needing time to reflect on all those years. After a short time, a smile came to her face and she answered proudly, explaining that she had first married a banker when she was in her early 20′s, then a circus ringmaster when in her 40′s, and a preacher when in her 60′s, and now in her 80′s, a funeral director.
Astonished, the interviewer looked at her and asked, “Why did you marry four men with such diverse careers?”
She smiled and explained, “I married one for the money, two for the show, three to get ready and four to go.”

Numbers can really be confusing. And when you are dealing with companies that back half of the $11 trillion home loans, things become even more confusing. What would you do about the role of the agencies in the mortgage industry? The National Association of Realtors has put forth a proposal to convert Freddie & Fannie into nonprofit corporations that would largely leave the mortgage-finance giants intact. Of course, the NAR or anyone else just can’t snap their fingers to make this happen: the proposal is likely to meet stiff political resistance because of the bail out money already spent and Congress’s desire to make bold changes. NAR suggests that unlike a federal agency, the new government non-profit authorities will function as self-sustaining organizations, without needing annual appropriations from Congress and without a profit motive but with government backing and guarantees. MI companies would continue to mitigate risk on loans above 80% LTV, and MBS guarantee fees would still be paid by originators. Of course no one wants to endanger the currently fragile housing and credit markets, least of all the NAR and Congress, so look for this process to be a very long and involved one.

Ripple Effects of Weak Consumer Confidence
The S&P Case-Shiller US National Home Price Index, besides claiming the longest name for an economic release, showed a 2.5% decrease in the fourth quarter from a year earlier. This was much less of a decrease than in previous quarters, and only a slight decrease from the prior month. In addition, Consumer Confidence slipped dramatically in February, going back to April ’09 levels. And if a consumer is not confident, don’t look for them to rush out and buy that new 3-D television! In fact, concerns about the economy and the labor market pushed an “index of current conditions” to its lowest level in 27 years and helped push the stock markets down. So not only did the bond market have those two items to help it rally, but there is renewed thinking that Greece’s fiscal crisis may spread to other nations, so there was some “safe haven” buying of U.S. government debt.

So the markets saw declining stocks, improving rates, still-slow (but improving) origination from mortgage companies, and a decent $44 billion 2-yr Treasury note auction. (This is the fifth consecutive month that the 2-yr sale has been $44 billion, and in the last month 2-yr yields have ranged from .72% up to .97% last Friday.) The Fed and money managers were in doing their usual buying. Generally speaking, continued global sovereign risk issues will continue to be a larger issue than, say, what last month’s economic news was, and thus investors may very well return to buying debt issues by the United States. And when folks like Federal Reserve Bank of San Francisco President Janet Yellen say that the U.S. economy will operate below potential this year and next and still needs low interest rates to gain strength that helps interest rates.

Revised Discount Rate Terms
Today we have New Home Sales, a 5-yr auction, and Ben Bernanke’s testimony for the Federal Reserve’s semi-annual monetary policy report to Congress. Last week the Fed raised the discount rate by 0.25 point to 0.75 percent, said the term of these direct loans to banks will revert to overnight next month from 28 days currently, and left Fed Funds unchanged at 0-.25%. There has been nothing to suggest an extension or expansion of the MBS purchase program, which ends March 31st, so it will be interesting to see what he says. Currently the 10-yr yield is at 3.70% and mortgage prices are a shade better.

New Private Mortgage Insurance Rules
Mortgage insurance company MGIC announced a set of pricing and criteria changes to be rolled out in March, most likely in response to losing market share to FHA loans and also to keep their #1 position among MI companies. The changes are set to occur in March, and the new pricing scale will use borrowers’ credit scores to set premium rates with lower prices for borrowers with the best credit history and higher premiums for those with worse scores. MGIC has lost money for ten straight quarters, so the company hopes this new grid will not only increase revenue but also shift their book of business toward borrowers with FICO’s above 720. For all markets and origination sources, MGIC will require a minimum of 3 tradelines evaluated for 12 months – otherwise the loan must meet MGIC’s nontraditional credit guidelines. More pricing and criteria here.

Quarterly Losses Narrow for Radian (a mortgage Insurance Company)
Speaking of MI companies, Radian said its fourth-quarter loss narrowed to $1.12 a share, better than the $1.69-a-share loss predicted by some, and the firm said it expects to have “excess liquidity” through 2012. Radian and others are seeing lower delinquencies with the newer product, as one would expect given tighter guidelines and less housing price depreciation.

Daily Humor
Three blondes were all applying for the last available position on the Texas Highway Patrol. The detective conducting the interview looked at the three of them and said, “So y’all want to be cops, huh?” The blondes all nodded.

The detective got up, opened a file drawer, and pulled out a folder. Sitting back down, he opened it, pulled out a picture, and said, “To be a detective, you have to be able to detect. You must be able to notice things such as distinguishing features and oddities like scars and so forth.”

So saying, he stuck the photo in the face of the first blonde and withdrew it after about two seconds, “Now,” he said, “did you notice any distinguishing features about this man?”

The blonde immediately said, “Yes, I did. He has only one eye!”

The detective shook his head and said, “Of course he has only one eye in this picture! It’s a profile of his face! You’re dismissed!”

The first blonde hung her head and walked out of the office.

The detective then turned to the second blonde, stuck the photo in her face for two seconds, pulled it back, and said, “What about you? Notice anything unusual or outstanding about this man?”

“Yes! He only has one ear!”

The detective put his head in his hands and exclaimed, “Didn’t you hear what I just told the other lady? This is a profile of the man’s face! Of course you can only see one ear! You’re excused too!”

The second blonde sheepishly walked out of the office.

The detective turned his attention to the third and last blonde and said, “This is probably a waste of time, but…” He flashed the photo in her face for a couple of seconds and withdrew it, saying, “All right, did you notice anything distinguishing or unusual about this man?”

The blonde said, “I sure did. This man wears contact lenses.”

The detective frowned, took another look at the picture, and began looking at some of the papers in the folder. He looked up at the blonde with a puzzled expression and said, “You’re absolutely right! His bio says he wears contacts! How in the world could you tell that by looking at his picture?”

The blonde rolled her eyes and said, “Well, Hellooooooooooooo! With only one eye and one ear, he certainly can’t wear glasses.”

Will the economic recovery continue?:

Participants expected the economic recovery to continue, but, consistent with experience following previous financial crises, most anticipated that the pickup in output and employment growth would be rather slow relative to past recoveries from deep recessions. A moderate pace of expansion would imply slow improvement in the labor market next year, with unemployment declining only gradually. Participants agreed that underlying inflation currently was subdued and was likely to remain so for some time. Some noted the risk that, over the next couple of years, inflation could edge further below the rates they judged most consistent with the Federal Reserve’s dual mandate for maximum employment and price stability; others saw inflation risks as tilted toward the upside in the medium term.

Bank standards likely to remain tight:

With rising levels of nonperforming loans expected to be a continuing source of stress, and with many regional and small banks vulnerable to the deteriorating performance of CRE loans, bank lending terms and standards were seen as likely to remain tight. Participants again noted the contrast between large and small firms’ access to financing. Large firms that can issue debt in the markets appeared to have relatively little difficulty obtaining credit. In contrast, smaller firms, which tend to be more dependent on commercial banks for financing, reportedly faced substantial constraints in gaining access to credit. While survey evidence suggested that small businesses considered weak demand to be a larger problem than access to credit, participants saw limited credit availability as a potential constraint on future investment and hiring by small businesses, which normally are a significant source of employment growth in recoveries.

Residential real estate and mortgage markets could face pressure as Fed’s MBS purchases wind down:

In the residential real estate sector, home sales and construction had risen relative to the very low levels reported in the spring; moreover, house prices appeared to be stabilizing and in some areas had reportedly moved higher. Generally, the outlook was for gains in housing activity to continue. However, some participants still viewed the improved outlook as quite tentative and again pointed to potential sources of softness, including the termination next year of the temporary tax credits for homebuyers and the downward pressure that further increases in foreclosures could put on house prices. Moreover, mortgage markets could come under pressure as the Federal Reserve’s agency MBS purchases wind down.

Banks could ease credit standards and also re-enter the private MBS market. This would help ease long-term mortgage rate pressure caused by end of Fed’s MBS purchasing, but could also lead to inflation which would cause Fed to hike short rates:

Moreover, a few participants noted that banks might seek, as the economy improves, to reduce their excess reserves quickly and substantially by purchasing securities or by easing credit standards and expanding their lending. A rapid shift, if not offset by Federal Reserve actions, could give excessive impetus to spending and potentially result in expected and actual inflation higher than would be consistent with price stability. To keep inflation expectations anchored, all participants agreed that monetary policy would need to be responsive to any significant improvement or worsening in the economic outlook and that the Federal Reserve would need to continue to clearly communicate its ability and intent to begin withdrawing monetary policy accommodation at the appropriate time and pace.

Fed will likely end MBS purchases by March 31, but it’s market dependent:

The Committee affirmed its intention to purchase $1.25 trillion of agency MBS and about $175 billion of agency debt by the end of the first quarter of 2010 and to gradually slow the pace of these purchases to promote a smooth transition in markets. The Committee emphasized that it would continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. A few members noted that resource slack was expected to diminish only slowly and observed that it might become desirable at some point in the future to provide more policy stimulus by expanding the planned scale of the Committee’s large-scale asset purchases and continuing them beyond the first quarter, especially if the outlook for economic growth were to weaken or if mortgage market functioning were to deteriorate. One member thought that the improvement in financial market conditions and the economic outlook suggested that the quantity of planned asset purchases could be scaled back, and that it might become appropriate to begin reducing the Federal Reserve’s holdings of longer-term assets if the recovery gains strength over time.

Jobless rate likely to stay near current levels:

The weakness in labor markets continued to be an important concern to meeting participants, who generally expected unemployment to remain elevated for quite some time. The unemployment rate was not the only indicator pointing to substantial slack in labor markets: The employment-to-population ratio had fallen to a 25-year low, and aggregate hours of production workers had dropped more than during the 1981-82 recession. Although the November employment report was considerably better than anticipated, several participants observed that more than one good report would be needed to provide convincing evidence of recovery in the labor market.

Inflation looks to be under control even with energy price increases:

The staff forecast for inflation was nearly unchanged. The staff interpreted the increases in prices of energy and nonmarket services that recently boosted consumer price inflation as largely transitory. Although the projected degree of slack in resource utilization over the next two years was a little lower than shown in the previous staff forecast, it was still quite substantial. Thus, the staff continued to project that core inflation would slow somewhat from its current pace over the next two years. Moreover, the staff expected that headline consumer price inflation would decline to about the same rate as core inflation in 2010 and 2011.

Fed’s take on the key determinants of inflation:

Inflation can respond to deviations of economic activity from its longer-run sustainable path. However, in some theoretical frameworks, the connection between resource slack and inflation depends on the nature of the shock and its impact on marginal costs and markups. Moreover, estimates of the magnitude of slack and its effect on inflation are sensitive to the details of the analytical framework and the statistical methodology used in each study. While theory suggests that the degree of slack prevailing in foreign economies could affect domestic inflation, empirical evidence on the importance of such an effect was mixed. Evidence suggested that sizable shifts in the longer-run inflation expectations of households and firms had influenced the evolution of inflation over previous decades; in contrast, the anchoring of inflation expectations in recent years likely had damped somewhat the response of actual inflation to the recent economic downturn and to fluctuations in the prices of energy and other commodities. In discussing these issues, participants noted that they bear in mind the shocks hitting the economy and regularly monitor more than one measure of resource slack as they assess the outlook for economic activity and inflation. They also noted the importance of formulating monetary policy in ways that would work well across a range of possible economic structures rather than relying on any one analytical framework. Finally, they underscored the importance of keeping longer-run inflation expectations firmly anchored to help achieve the Federal Reserve’s dual mandate for maximum employment and price stability.

The Fed mortgage bond purchase program will continue through March 31. This is the most important factor in keeping mortgage rates low because buying drives bond prices up and yields (or rates) down. For the latest on this mortgage bond buying program and what it’s doing for rates now and during early-2010, click here. And the Fed’s full statement is below.

Full Statement
Information received since the Federal Open Market Committee met in November suggests that economic activity has continued to pick up and that the deterioration in the labor market is abating. The housing sector has shown some signs of improvement over recent months. Household spending appears to be expanding at a moderate rate, though it remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment, though at a slower pace, and remain reluctant to add to payrolls; they continue to make progress in bringing inventory stocks into better alignment with sales. Financial market conditions have become more supportive of economic growth. Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.

With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. In order to promote a smooth transition in markets, the Committee is gradually slowing the pace of these purchases, and it anticipates that these transactions will be executed by the end of the first quarter of 2010. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.

In light of ongoing improvements in the functioning of financial markets, the Committee and the Board of Governors anticipate that most of the Federal Reserve’s special liquidity facilities will expire on February 1, 2010, consistent with the Federal Reserve’s announcement of June 25, 2009. These facilities include the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility. The Federal Reserve will also be working with its central bank counterparties to close its temporary liquidity swap arrangements by February 1. The Federal Reserve expects that amounts provided under the Term Auction Facility will continue to be scaled back in early 2010. The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility remain set at June 30, 2010, for loans backed by new-issue commercial mortgage-backed securities and March 31, 2010, for loans backed by all other types of collateral. The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth.