The Federal Reserve today announced its intention to replace the expiring "operation twist" with a new round of open-ended purchases of U.S. Treasuries by an equal amount monthly.
The U.S. Treasury market initially sold off on the announcement, which sent yields on the 10- and 30-year issues up by about 3 and 5 basis points, respectively. This appears to be an immediate example of "buy the rumor, sell the fact" as the size of the new program is what was widely anticipated.
But on a longer-term basis, the Fed is now committed to buying $40 billion of mortgage backed securities monthly and $45 billion worth of U.S. Treasuries monthly, both of which should force Treasury yields and mortgage rates lower.
According to the Fed's press release "these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative."
There is a key word in the federal Open Market Committee (FOMC) press release from today that was not in the September 13 2012 press release announcing the implementation of QE3 and the intention to purchase $40 billion of mortgage backed securities monthly. That word is "initially," which I think it's important.
In the announcement today the Fed stated: "The Committee also will purchase longer-term Treasury securities after its program to extend the average maturity of its holdings of Treasury securities is completed at the end of the year, initially at a pace of $45 billion per month."
My immediate impression is that the Fed is leaving itself room to increase the size of these purchases without having to announce a change in policy or another round of QE with the determination to do being predicated on the performance of the QE3.
About 58% of all securities held by banks today are in the form of mortgage backed securities, with about 6.5% in U.S. Treasuries, 7.5% in U.S. government agency debt, 8.5% in state and municipal debt, 12% in foreign debt and 8% in non-real estate related asset backed securities.
The Fed is steering the banks into making more mortgage loans at lower rates and encouraging them to redeploy the income from selling these loans to the Fed into more productive loans and securities and away from retaining mortgage backed securities and Treasuries.
There is nothing new in this, but the banks have so far opted to reinvest income from the origination and sale of mortgages back into mortgage backed securities rather than into new and non-securitized loans or into asset backed securities. There are signs that this forced search for yield has produced results as bank holdings of state and municipal debt have increased from about $160 billion to $250 billion in the past three years.
There has been little change in bank holdings of asset backed securities or loans originated and held as portfolio investments. The bottom line is that the Fed is now embarking on a program of driving yields on the safest investments so low that banks will have to start lending into the productive economy again. The wording in today's press release makes clear that the Fed is ready to accelerate the process of driving Treasury yields and mortgage rates down even faster if it decides to.