Ben S. Bernanke’s Federal Reserve signaled this week it isn’t ready to buy more bonds to stimulate the economy. Mortgage investors aren’t convinced.
Trading in the market for government-backed mortgage bonds is showing a 37 percent chance of a third round of so-called quantitative easing, or QE3, according to Credit Suisse Group AG calculations. While that’s declined from 40 percent last week, it’s up from 25 percent after the April 3 release of the minutes of the Fed’s monetary-policy panel meeting last month.
Stocks, commodities and bonds declined after the statement, which showed certain members support easing only “if the economy lost momentum.” Treasuries (USGG10YR) and mortgage securities pared losses yesterday with some investors speculating the Fed will eventually acquire more home-loan debt to bolster consumer spending and support a housing market the minutes described as “depressed.”
“Mortgages didn’t underperform in a truly meaningful fashion,” said Jason Callan, head of structured products at Columbia Management Investment Advisers LLC in Minneapolis, which oversees about $180 billion in fixed income. “The likelihood of QE was modestly diminished, particularly in terms of the April meeting, but that doesn’t take it off the table for later.”
After Fannie Mae’s 3.5 percent, 30-year mortgage securities underperformed similar-duration interest-rate swaps by 0.34 cent on the dollar on April 3, the most since October, the home-loan notes outperformed by 0.25 cent yesterday, according to data compiled by Bloomberg.
Bellwether to Buying
Trading in the $5.4 trillion market for so-called agency mortgage securities relative to fixed-income benchmarks such as Treasuries and interest-rate swaps is serving as a QE3 bellwether because any program may focus on home-loan bonds after Fed Chairman Bernanke sent a study to Congress in January that highlighted how housing is restraining the economic recovery.
The central bank acquired $2.3 trillion of bonds in two rounds of quantitative easing from December 2008 until June 2011, including $1.25 trillion of agency mortgage securities. In September it announced it would buy $400 billion of longer-term U.S. securities through June while selling an equal amount of shorter-term debt in its holdings, and start reinvesting proceeds from its housing debt back into the mortgage market.
The probability being assigned to QE3 is now “too high,” Credit Suisse analyst Mahesh Swaminathan in New York, said in an e-mail. After the Fed’s statement, his team recommended bets that mortgage bonds will underperform, based on the central bank’s “incrementally hawkish sentiment.”
Four Federal Reserve regional bank presidents who vote on monetary policy this year said this week they see less of a need for the Fed to spur the economy with new accommodation.
Richmond’s Jeffrey Lacker said yesterday he “was surprised a couple months ago at the probability market participants seemed to ascribe to further easing.”
Jobless claims fell 6,000 to 357,000 in the week ended March 31, the fewest since April 2008, the Labor Department reported today in Washington.
A report on the state of the U.S. job market tomorrow also may show the unemployment rate held at 8.3 percent, according to estimates compiled by Bloomberg. While that would match the rate in January and February, the lowest in three years, it may provide the Fed with evidence that consumers and housing need additional help.
Home-loan securities guaranteed by government-supported Fannie Mae and Freddie Mac and U.S.-owned Ginnie Mae have returned 0.99 percentage point more than Treasuries this year through April 4, according to Barclays Plc index data. The rally was partly driven by investors who anticipate QE3, such as Pacific Investment Management Co. (PTTRX)’s Bill Gross.
The Fed has already helped push borrowing costs on new mortgages to record lows. Almost 90 percent of new home lending goes through government-supported programs fueled by the agency mortgage-bond market, making the debt key to the level of loan rates, according to newsletter Inside Mortgage Finance.
Even with that assistance, the housing recovery remains fragile. Property prices dropped five consecutive months to a 10-year low in January, according to an S&P/Case-Shiller (SPCS20) home- price index. New-home sales fell to a 313,000 annual pace in February, the slowest since October, the Commerce Department said March 23. Existing-home sales eased to a 4.59 million annual rate from January’s 4.63 million pace, according to the National Association of Realtors.
After the release of the Fed minutes, “we went from 55 percent odds in favor of easing to 45 percent,” said David Ader, head of U.S. government-bond strategy at CRT Capital Group LLC in Stamford, Connecticut. “There’s a slight bias that we don’t get it. But the fact remains that it’s data-dependent,” or tied to new information on the economy.
Projected economic growth is “far from robust,” said Columbia Management’s Callan. There’s also a “potentially massive fiscal headwind as we turn the calendar to next year,” including items such as the expiration of tax cuts originally passed under President George W. Bush, he said.
“I agree with the general sentiment, it’s data-dependent,” he said. “I just don’t believe economic growth has achieved escape velocity. Most of the larger data points have modestly underperformed expectations as of late.”
The Citigroup Economic Surprise Index has fallen to 6.8, the lowest in six months, after reaching 93.2 on Jan. 6, the highest in ten months. Readings below zero mean reports are missing the median estimate in Bloomberg surveys.
Gross domestic product in the U.S. will probably expand 2.2 percent in 2012, according to the median estimate of more than 70 economists surveyed by Bloomberg. That’s slower than the 3 percent posted in 2010, the first year after the end of the recession.
“The data flow will lend itself quite comfortably to the potential of another round of asset purchases,” said Tom Porcelli, chief U.S. economist at RBC Capital Markets and a former economist at the Federal Reserve Bank of New York. “The first half of this year will be soft enough for the Fed to respond to it.”
Porcelli said the markets had “a massive over-reaction,” considering public comments by Bernanke that came after the March 13 meeting of Fed policy makers. In a March 27 television interview with ABC News, The Fed chairman said that “we haven’t quite yet got to the point where we can be completely confident that we’re on a track to full recovery.”
Europe’s Debt Crisis
Europe’s sovereign debt crisis is also a consideration for the Fed. Spanish 10-year yields surged 0.24 percentage point yesterday to 5.69 percent, helping to extend losses in stocks and commodities and pare a rise in Treasury yields.
The Standard & Poor’s 500 index of stocks fell 1.4 percent over two days, the biggest two-session decline in almost a month. The S&P GSCI Index tracking 24 commodities fell 2.4 percent. Yields on 10-year Treasuries advanced 0.12 percentage point to 2.3 percent on April 3 before falling yesterday to 2.22 percent.
Yields on Fannie Mae’s 3.5 percent mortgage securities rose 0.16 percentage point to 3.05 percent on April 3, the highest in two weeks, before falling to 2.96 percent yesterday, Bloomberg data show.
Using a different methodology than Credit Suisse, JPMorgan Chase & Co. analysts have cited lesser odds of QE3 being priced into the mortgage-bond market.
By last week, their measure showed a perceived 20 percent chance, down from 60 percent to 70 percent a month ago. Their approach is based on one-week changes in the performance of mortgage bonds relative to Treasuries as yields move up and down, observed over one-month periods.
Money managers such as mutual funds may not have much room to buy more mortgage bonds if the Fed doesn’t, according to surveys by the New York-based JPMorgan analysts led by Matt Jozoff. Last week, about 62 percent were overweight the debt, or holding more than in benchmark indexes, compared with 11 percent who were underweight, down from almost 30 percent in August, according to the polls.
Gross increased the mortgage holdings of Pimco’s $252 billion Total Return Fund to 52 percent in February, according to data on the company’s website.
“Without QE, the financial markets and then the economy will falter,” wrote Gross, who oversees the world’s biggest bond fund, in a Twitter post yesterday.