12/10/12 – Possible Outcomes of This Week’s Fed Meeting

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Dec 10, 2012 6:28:28 AM

and tagged Market Updates

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— Fred DeBaets

On Wednesday, we expect the Fed to announce the continuation of Treasury purchases to replace the current maturity extension program, better known as Operation Twist. The Fed will likely grow the balance sheet at a rate of $45 billion per month, maintaining the current pace of purchases. As for the time frame, our best guess is that the new program will end approximately six months prior to the anticipated rate hike, currently projected as mid-2015 by the Fed and early 2016 by the Fed futures market.

We don’t expect the Fed to change its target rate or language regarding low rates at this time. Factoring in QE3’s announcement of $40 billion in mortgage-backed securities (MBS) purchases, the combined $85 billion in total monthly purchases could easily add up to well north of $1 trillion in total purchases on a net basis over the next couple of years, essentially taking supply out of the market. (Look for a post on this topic soon.)

Given the Fed’s ongoing attempt to lower long-term rates, its purchasing is likely to be focused on the long end of the curve (10-year and out). The Fed currently holds approximately $400 billion of short-term securities—very little in terms of the big picture—and that’s why we see it growing the balance sheet and not selling current holdings. Selling intermediate securities while purchasing longer-dated ones, however, could have a negative or inverse effect on what the Fed seeks to accomplish. While general market demand historically stands on the shorter end of the curve, where most of the outstanding U.S. debt exists, the open market will likely keep rates low on the short end while the Fed takes care of the long end.

Although many questions remain about how effective Treasury purchasing has been, there is strong evidence that MBS purchasing continues to have the desired effect, pushing mortgage rates to new historical lows. With no end in sight on MBS purchasing, we would expect rates to remain lower for the better part of next year.

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