The past couple of weeks have been filled with various Federal Reserve governors and presidents rattling their monetary sabers, threatening to raise the Fed Funds Effective Target Rate anywhere from two to four times in 2016. The more hawkish members of the Fed want to “normalize” monetary policy soon. Raising overnight rates, however, isn’t really what the world wants as evidenced by the global markets reaction to the aggressive “Fed-Speak.”
For the month of May, the U.S. Dollar (USD) is up 2.7% (as measured by the Bloomberg Dollar Index), the Chinese Yuan is weaker against the USD by 1.6%, and emerging markets are down 3.8% (as measured by the MSCI Emerging Market Index). With regard to China, I think it is apparent that Chinese and U.S. monetary policy are joined at the hip. If the Fed tightens, the Peoples Bank of China either has to tighten as well or let their currency devalue. The first choice could create the “hard landing” of the Chinese economy the world has been dreading. The second choice could launch a currency war in Asia. Neither outcome is a good thing for anyone. Additionally, in my opinion, commodity prices and other risk assets will suffer should the USD continue to march higher.
Therefore, the real normalization policy that I think makes the most sense is for the Fed to leave the Fed Effective Rate alone for now. Instead, the Fed should decrease its monthly reinvestment purchases of Agency Mortgage-Backed Securities (MBS) and, in turn, buy short-dated U.S. Treasury notes, steepening the yield curve. If the Fed really wants to start normalizing monetary policy and begin to actually allow financial markets to trade freely again, give the masses what they want!
Many institutions, both domestic and global, that have billions of long-dated liabilities need this duration. I spoke of this in my piece a couple of weeks ago, “The Money River Keeps on Rolling.” The Fed has cut off the money river’s access to major sources of USD rate duration through their Quantitative Easing (QE) programs. The Fed has a U.S. Agency Mortgage-Backed Security (Fannie Mae, Freddie Mac, and Ginnie Mae) portfolio of $1.6 trillion, and while they stopped adding to the portfolio in 2014, they still reinvest the pay-downs on the portfolio through daily operations. The Fed buys $25–$30 billion mortgage-backed securities per month and that is a major take out of supply and a major distortion of the market. The problem is: since it has been going on for about seven years, removing the Fed from the market would be very disruptive, at least initially.
However, from a long-term and a global perspective, this would be a good thing, in my opinion. If the Fed tapered off their monthly purchases, at least by half, they would be providing a USD duration-starved market an additional $12–$15 billion a month. This would allow many investors to diversify their sector risks as opposed to returning again and again to the corporate bond and equity trough, elbowing each other out of the way to buy whatever happens to be available. Naturally, this would create short-term chaos in the mortgage market, increased lending rates, and steepen the yield curve. There would be cries from the Paul Krugmans of the world that a move like this will destroy the housing market and derail our economic recovery.
However, I think after the initial shock, we still have the same domestic and global investors just as hungry for USD duration as they were before any “Fed MBS Tapering.” Investors will eventually step into the breach to buy the new supply of MBS keeping yields, and hence primary mortgage rates (the rates offered to borrowers), still relatively low. We have come to believe that 30-year fixed mortgage rates of 4% and lower are normal. They are not. Rather, they are artificial rates, held down directly by the Fed’s QE program.
To a large extent, the housing market has incurred about as much growth as it can from these artificially low rates. A tell-tale sign of this is Wells Fargo’s new “Your First Mortgage” program. Essentially, Wells Fargo has side-stepped the Federal Housing Administration (FHA) and is now offering conventional mortgages to first-time homebuyers at a miniscule 3% down payment, as well as many relaxed underwriting standards. Basicaly, we are taking people who do not have the financial capital to put at least 10% down on a house and can’t qualify to borrow the remainder at historically low mortgage rates, and stuffing them into houses that they can’t afford. Sound familiar?
Moreover, while a strategy like this is disruptive, the bandage has to be ripped off sometime. The Fed has just been kicking this can down the road. At some point, the $25–$30 billion that their mortgage portfolio pays down a month has to be allowed to run off. The plan wasn’t to reinvest into perpetuity. Why not start now when the world is hungry for the duration the Fed would be adding? Also, by letting longer duration mortgages run off and purchasing shorter duration treasuries, the Fed’s $4.5 trillion balance sheet matures faster and the USD does not get uncomfortably high. Additionally, the yield curve will steepen: a boon for banks. With regard to the last point, maybe a steeper yield curve can help prevent banks like Wells Fargo from creating the Sub-Prime Lending Crisis Part II.
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