How Does Fed Mortgage Bond Buying Affect Rates?

The following post was a section of a previous post but we’re pulling it out as it’s own post because people keep asking about it.

When the Fed started buying mortgage bonds five weeks ago, the goal was to push mortgage bond prices up and yields (or rates) down. Since the program was announced in November, markets went wild with rumors of 4.5% rates. Below is a breakdown of what’s actually going on … keep in mind that this rate discussion is focused on loans up to $417k.

When the Fed program started, it was thought they’d buy mostly 4% coupons, and since mortgage bonds at this level represent consumer rates of about 4.5% to 5%, that’s why there was buzz about 4.5% rates. Instead they’ve focused heavily on higher coupons, especially the 5.5% coupons in recent weeks, which represent outstanding loans in the 6% to 6.5% range. This does two things: (1) it drives rates down enough to allow existing mortgagees with these 6% to 6.5% rates to refinance, and (2) It provides quick payback on the Fed’s investment when these loans refi.

If the Fed isn’t heavily buying lower coupons like 4% and 4.5%, it doesn’t help drive rates down to the levels often discussed in the press. Also not helping rates to drop lower is private selling pressure. Right after the Fed announced their MBS buying program on November 24, private investors piled into lower-coupon MBS as a way to get in ahead of the government buying, which brought zero-points rates from 6.375% to 5.125% as of January 5.

But now private investors are selling to take profits and the Fed is focusing on higher coupons, so both of these factors work against zero-points sub-5% rates. As of today, zero-points 30yr fixed mortgages up to $417k are about 5.375% versus 5.25% two weeks ago. Remember: these are average rates on loans up to $417k. If buyers pay one point (1% of the loan amount), they will get 5%. Better and worse rates are present in the marketplace.

So why is the Fed focusing on higher coupons? They need to spread out their budget as long as possible. So even if rates don’t drop significantly from here, the Fed’s strategy makes it unlikely that rates will spike near term. And again, the 1-point rates are still highly attractive and record lows.