What is likely to happen to mortgage rates tomorrow after the Fed statement is released? The best answer is that it will be extremely volatile. The majority view is that the Fed will begin to taper its bond purchase program, but the reaction in the mortgage market will depend on the details. The first question is the size of the reduction. Investors expect the Fed to cut its monthly purchases from $85 billion to around $70 billion. It is also uncertain how the reduction will be split between MBS and Treasuries. We would not be surprised if the Fed cut only Treasury purchases and left MBS purchases unchanged, since several Fed officials have stated that MBS purchases provide a greater boost to the economy than Treasury purchases. In addition, it will be important to hear how the Fed plans to determine future reductions. Of course, there is no guarantee that the Fed will announce a taper on Wednesday at all. Investors have taken positions based on their expectations for the Fed statement, and there likely will be a large reaction tomorrow afternoon following its release.
A couple of months ago, Fed Chief Bernanke was answering questions about the Fed's plan to sell its MBS portfolio. He stated that the Fed would eventually return its balance sheet to normal by selling the $1.25 trillion in MBS it had bought to stimulate the economy, but that it would not take place soon. While some Fed officials were pushing for a faster start date, investors believed that the MBS sales were likely to begin early in 2011. As the economic outlook has grown weaker, however, the Fed's likely plans have changed. Rather than discussing a start date for Fed tightening moves, Fed officials are now outlining options and conditions for adding further monetary stimulus. In particular, the Fed had been planning to allow the MBS in its portfolio to mature without replacing them. Due to defaults, refinancings, and maturities, some MBS "roll off" the Fed's portfolio over time. Until recently, investors expected the Fed to let its portfolio slowly shrink in this fashion, which would represent a minor amount of monetary tightening. Tuesday, though, a Wall Street Journal article suggested that Fed officials are considering whether to replace those securities to stimulate the economy. With the next Fed [...]