One source of volatility for MBS prices is uncertainty about the outcome of upcoming elections in several European countries. Investors are most focused on the presidential election in France which will take place on April 23. Polls show a close race between Marine Le Pen and Emmanuel Macron. Le Pen's campaign has been centered on plans for France to leave the European Union (EU) and to stop using the euro currency, while the centrist Macron has run on a more traditional platform. It is not clear what would happen to the EU if France decided to exit. As a result, investors have reacted by shifting to safer assets after news which favors a Le Pen victory and doing the opposite after positive news for Macron. Since U.S. MBS are viewed as relatively safer assets, they have been affected by the shifts in sentiment, causing volatility.
In her semi-annual testimony to Congress, Fed Chair Yellen said that the Fed expects that economic progress will call for "further gradual increases" in the federal funds rate. She also said that it would be "unwise" to wait too long to hike rates. Yellen later added that the Fed will consider in coming months when to begin to reduce the Fed's holdings of MBS. Of note, she said that the Fed will not sell MBS to shrink the holdings, but rather will stop replacing principal reductions. The expected pace of tightening by the Fed increased a little after her testimony, causing MBS to decline.
As widely expected, the Fed raised the federal funds rate by 25 basis points. Unfortunately for MBS, Fed officials also raised their outlook for the pace of future rate hikes. They now forecast three rate hikes in 2017, one more than previously projected. The faster pace was viewed as negative for mortgage rates. But why? The purpose for raising the federal funds rate is to keep inflation from rising above the Fed's target of 2%. This should be a good thing for mortgage rates. Part of the reason for the adverse reaction stems from a more direct effect the Fed has on mortgage rates. The Fed owns over $1.7 trillion of the agency mortgage-backed securities (MBS) that it purchased during its quantitative easing (QE) days. The Fed keeps the balance of MBS around that level by buying new MBS to replace that which pays off. The Fed is currently the buyer of approximately 25% of all newly issued MBS. This added demand from the Fed drives MBS prices higher and mortgage rates lower. The Fed says that it will not allow its holdings of MBS to decline until "normalization of the level of the federal funds rate is well under [...]
Fed day is coming up on Thursday. The Statement will be released at 2:00 ET, and Fed Chair Yellen’s press conference will follow at around 2:30 ET. Fed members appear divided about raising the federal funds rate at this meeting. Investor expectations are mixed as well. With no apparent consensus, whatever the Fed decides will likely cause a significant reaction in the markets. More important than the decision about hiking rates may be what investors learn about the Fed’s view of the economy and how that may influence future Fed policy. What impact will this Fed meeting have on mortgage rates? The answer is not at all clear. It will depend on how the Fed’s decision and comments alter investors’ outlook for future Fed policy.
The Wall Street Journal reported that during tomorrow's European Central Bank (ECB) meeting the executive board of the ECB will recommend to the entire 25-member governing council a plan to begin a sovereign bond purchase program. The plan, which would be similar to the quantitative easing (QE) program used by the US Fed in recent years, would call for purchases of 50 billion euros (about $58 billion) per month for a minimum of one year. These figures are roughly in line with investor expectations, and the reaction in MBS markets has been small so far. If the governing council adopts this plan tomorrow, the impact on MBS may be small.
At the beginning of the year, a change was made to allow the Producer Price Index (PPI) to capture a wider range of items. PPI now focuses on the increase in prices of intermediate goods AND services used by companies to produce finished products. Services were not included before this year. One result of the change was to make the data more volatile month to month. Investors likely will look at longer-term trends in PPI, but they may not react much to monthly changes, as was seen today. To determine trends in inflation, investors rely more heavily on the Consumer Price Index (CPI), which measures price changes for finished goods, and the Core PCE price index, which is favored by the Fed.
In a speech this morning, Fed Chair Yellen said that Fed officials widely share the view that further improvement in the labor market is needed before the Fed should begin to raise the fed funds rate. According to Yellen, the US economy is still "considerably short" of the Fed's goals. She emphasized several measures indicating that considerable slack remains in the labor market. The labor force participation rate remains low by historical standards. A lot of people who could be working have become discouraged by their lack of success in finding a job and have stopped trying. Seven million people are working part-time, and many of them would prefer to be working full-time. A large number of people have been unemployed for six months or more, which looks bad when applying for jobs. The JOLTS data shows that few people are quitting their jobs voluntarily. When the labor market is stronger, people typically are more willing to risk seeking better opportunities. Finally, wage gains have been small. Yellen's comments suggested that the Fed may wait longer than expected to raise the fed funds rate, which lifted stocks and had little lasting impact on MBS.
In a press conference this afternoon, President Obama laid out his plan for restructuring the GSEs. His plan sounds very similar to what is being proposed in the Senate, so there were no big surprises. His plan includes a wind down of Fannie and Freddie (no specific timetable provided) to make room for the private sector. His plan includes some form of government backstop, as necessary to encourage a liquid market for mortgage-backed securities (MBS) and the 30 year fixed rate product. The government backstop would insure investor recovery of principal and interest, but would only be paid after substantial private capital has been depleted. He acknowledged that this will take a long time. He offered a couple of things that could be done much sooner, like creating a common Fannie/Freddie platform for issuing new MBS and reducing Fannie’s and Freddie’s mortgage holdings. He emphasized that any restructuring needs to provide adequate opportunity for first time home buyers.
There was very little change in today's Fed statement from the prior statement released on June 19. Investors viewed this as good news for MBS, since the most likely potential changes would have been negative for MBS. For example, some investors thought that the Fed would provide more concrete guidance on the timing to begin to taper its bond purchases. Instead, by avoiding specifics, Fed officials left the timing more open-ended. A decline in the quantity of Fed bond purchases will be negative for MBS. The primary change to the statement was the Fed's description of the economy. The statement said that the economy is growing at a "modest" pace, while the last statement said that the pace of economic growth was "moderate". The statement noted that Fed officials expect inflation to rise moderately over the medium term, but that there is a risk that it will decline to undesirable levels. The consensus view is still that the Fed will begin to taper its bond purchases in September, unless economic growth weakens significantly. Friday's Employment report will be one of the major upcoming data points which will influence future Fed policy.
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