Shop Till Rates Drop: Fed to continue its buying spree

Banking professionals have dealt with a non-stop series of precedents for an extended period of time, which now has stretched into fully five years.  Most of these events have not been particularly welcome by community banks.  As we get into 2013, we have been fully warned that there will be another externality that will, at least in the short term, keep bank earnings constrained.

The Federal Reserve’s Federal Open Market Committee has been buying large amounts of bonds since late 2008.  It launched this “quantitative easing” (QE) strategy pretty much concurrently with the demise of Fannie Mae and Freddie Mac, along with other watershed banking events like the bankruptcy of Lehman Brothers and the failure of Washington Mutual.  The Fed’s own balance sheet grew by more than $1 trillion in the 90 days after Sept. 10, 2008.

That spending has continued apace.  There have been several different phases of the QE strategy (Fed paparazzi consider it to be on QE3), but the result has been the same:  Lower interest rates, and lower yields on bonds.  Including the ones in your bank’s investment portfolio.

Early goals
Originally the plunge head-long into the bond market back in 2008 was to calm it down.  Profitable, well-capitalized organizations were having great difficulty financing even their money market obligations, and the U.S. economy was teetering on a complete freeze-up.  Borrowing costs absolutely spiked.  The massive intervention by the Fed brought some reason back to the fixed-income market.

As an example, a two-year agency bullet security, which is an extremely liquid (and therefore low-yielding) instrument, averaged a yield spread of around 33 basis points over the benchmark Treasury note for the entire year of 2007.  For several weeks in late 2008, it widened out to over 150 basis points.  The QE strategy got spreads down to normal by spring 2009.  Mission accomplished.

Current strategy
The financial markets, if not churning out record profits, are at least calm.  This is due in no small part to the Fed’s continued vigilance, its public statements, and its participation in the bond market.  One indication of the calm is that our two-year agency bond now has a whopping spread of three basis points (0.03%) over Treasuries.

More visible to portfolio managers is that the Fed announced in Sept. 2012 that it will be buying $40 billion of mortgage-backed securities (MBS) each month until it decides that it’s not.  This is in addition to the $45 billion of “longer-term” Treasuries it will be buying each month.

In round terms, that adds up to an additional $1 trillion in policy accommodation in 2013 alone.  The Fed’s balance sheet cracked the $3 trillion barrier for the first time in January, and it will likely be over $4 trillion by the end of the year.  This is widely expected because the Fed, most politely, has said that it wants the unemployment rate under 6.5 percent and inflation projections over 2.5 percent before it changes course.  Those two objectives could take many quarters to achieve.

What this means to you
Good news: The value of your current portfolio has probably been insulated against substantial declines for a while.  Bad news:  The available yields on your new purchases are going to be unimpressive.  In particular, mortgage securities will require your attention.

The ongoing accumulation of MBS is quite stunning in sheer scope.  For example, new issuance of mortgage securities in 2012 averaged about $150 billion per month.  The Fed’s appetite will gobble up fully one quarter of these.  And be aware also that the total amount of mortgage debt outstanding has declined more than ten percent since 2008, as homeowners are still struggling with negative equity and deleveraging.

Community banks have record-high exposures to prepayment risk, thanks to the premium prices that have accumulated on all things MBS.  With the Fed’s ambitious, and unambiguous, plans for continued buying staring at the market, it behooves investors in these products to have a firm handle on possible outcomes. And stay tuned for updates on the Fed’s shopping bonanza.

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