Federal Reserve officials wrapped up their latest meeting (which occurs every six weeks) and announced what most market watchers expected them to announce: The Fed will shrink its massive balance sheet. The balance sheet holds mostly Treasury securities and mortgage-backed securities (MBS) -- roughly $4.5 trillion of them.
The Fed’s new policy has widespread ramifications. The Fed’s balance sheet correlates positively with base money supply. The larger the balance sheet, the more money the Fed has injected into the economy.
Here’s how it works: Primary dealers (mostly investment banks) buy Treasury securities and MBS and then turn around and sell them to the Fed. The Fed pays with newly minted money. Fed demand for the securities and the influx of new money work to keep interest rates low.
Now the Fed is ready to reverse course.
After massively expanding its balance sheet (and the base money supply) following the 2008 financial crisis, the Fed seeks to shrink its balance sheet (and the base money supply) to more normal levels. The Fed had long ago ceased expanding its balance sheet with new purchases. The modus until now has been simply to reinvest the proceeds from maturing Treasury securities and MBS into newly issued Treasury securities and MBS, thus holding the base money supply high but steady.
Going forward, the Fed plans to retain more of the money received from maturing Treasury securities and MBS. This will reduce the Fed’s demand for Treasury securities and MBS. It will also reduce the money supply. Lower demand and reduced money supply could keep interest rates on a rising trajectory.
Interest rates rose into the Fed’s meeting last week. Market participants anticipated the Fed’s plans, and anticipation was manifest in rising interest rates.
But how quickly will rates go up?
Not quickly at all.
The Fed’s plan is to start with a $10 billion roll off in October, which will increase quarterly until it reaches $50 billion by October 2018. Considering the Fed’s balance sheet holds $4.5 trillion of securities, we’re looking at a slow, multi-year reversing process.
Fed Chair Janet Yellen was also quick to hedge. Yellen mentioned that “policy is not on a preset course.” In other words, if conditions warrant, the Fed could quickly reverse course.
There is an old saying pertinent to financial markets: “Buy the rumor, sell the news.” Act one way on rumor, act the other way when the rumor is confirmed. If past is prologue, mortgage rates could dip again in the coming weeks as more market participants act the other way.
Blame It on Harvey?
Home builder sentiment eased in September after rallying in August. Most of the easing occurred in the South, which was impacted by two hurricanes.
Sentiment was down despite home starts rising nationwide in August. Single-family starts were up 1.6% to 851,000 units on an annualized rate. Starts should show more growth once the water subsides in Texas and Florida. Additional building will occur to replace lost homes.
As for existing homes, sales were down 1.7% in August. Hurricane Harvey was to blame. Overall sales were dragged down by a decline in sales in the South. No surprise here: Buying and selling will always take a backseat to surviving.
Of course, there’s more to current existing-home sales than hurricanes. Lack of inventory continues to bog down sales in many markets. But some reprieve has occurred on pricing: The median price of an existing home actually fell 1.8% to $253,500 in August.
The good news is that this too shall pass (hurricane season). The housing market remains healthy. Near-term Interest-rate uncertainty and immediate weather won’t change that. We still expect housing to lead the economy (as it has) into 2018.
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