Costas Bocelli Another Brick in the Wall:
The Fed is Twisting Your Arm to Do These 2 Things

Costas Bocelli

In the Fed’s widely anticipated policy statement yesterday afternoon, the FOMC announced another round of monetary easing to try and jump start the struggling economy.

After admitting that the current economic conditions pose “significant downside risks” to the recovery, the Committee reached the decision to alter the composition of their $2.9 trillion balance sheet:

The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less.

In what has been named “Operation Twist” from a similar measure taken nearly 50 years ago, this tool is designed to reduce long term interest rates, which essentially makes the cost of capital cheaper for businesses and consumers to boost borrowing and spending.

The Fed has been under enormous pressure and scrutiny over the last several unorthodox attempts at easing monetary policy, particularly the last two rounds of Quantitative Easing (QE1 and QE2), which bloated the balance sheet to its current level.  The side effects have had a profound impact on consumers because of sharp increases in inflation and prices.

Not only have nearly 30% of the voting members on the Committee officially dissented to additional easing measures, but the Republican leadership in Congress made their feelings known by sending a stern letter ahead of this meeting to the Fed Chairman warning not to engage in further easing for fear of higher inflationary conditions.

So it appears as if there won’t be a QE3 anytime soon, unless the economy takes a severe turn for the worse.  The markets were sorely disappointed by this revelation, as they tumbled nearly 3% after the announcement yesterday afternoon, and are off to an even worse start today as I write this.

Aside from the portfolio shift further out along the yield curve, the Committee did make another compelling change to policy:

To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.

This is clear evidence that the Fed is trying to do everything possible to “twist the arms” of the American consumer — particularly those who’ve been sitting idle on the “white picket” fence — to go out and grab their piece of the “American Dream” and buy a home.

In their last policy statement in August, the Fed implicitly pledged to keep short term rates low until 2013, which also drove down longer term rates further out along the curve.  Last month’s actions dropped mortgage rates to historic lows.

Yesterday’s reading on Existing Home Sales showed a month over month jump of almost 8%, to an annualized rate of 5.03 million homes sold.

Now, instead of reinvesting the proceeds from maturing mortgage backed securities directly into Treasuries like they have been doing, they will reinvest the proceeds directly back into mortgage agency debt (Fannie and Freddie), which should squeeze mortgage spreads to tighten and lower residential mortgage rates even further.

The Fed is indeed doing everything that it can to boost the housing market while not increasing the balance sheet.

I would not be surprised to see the average 30-year fixed mortgage rate being quoted below 4.00% as early as next week.