Everyone Gets It Wrong: The Fed Won't Taper


Federal Reserve building in Washington D.C. Source: Flickr Creative Commons (image creator: DonkeyHotey).

Analysts and commentators were certain that it would happen this time.

"The only uncertainty here is the amount of tapering that occurs," a trader of government securities told Bloomberg News.

"After three iterations over five years," Michael J. Casey of The Wall Street Journal wrote this morning, "quantitative easing appears to be entering its end game."

Clearly, the Federal Reserve didn't get the memo. This afternoon, the committee responsible for setting monetary policy announced that it had voted overwhelmingly (9 to 1) in favor of continuing its present course.

The only dissenting member was Esther George, the president of the Federal Reserve Bank of Kansas City, who was "concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations."

As the central bank explained in the accompanying press release:

Taking into account the extent of federal fiscal retrenchment, the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program a year ago as consistent with growing underlying strength in the broader economy. However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.

The reaction to the news was palatable. Immediately following the announcement, the S&P 500 shot higher by nearly 20 points, or more than 1%.

Over the last few months, interest rates on everything from government securities to residential mortgages have shot higher in anticipation of the Fed's decision to reduce its support for the economy.

The rate on the benchmark 10-year Treasury went from 2% at the end of May all the way up to nearly 3% at the beginning of this month. And mortgage rates have similarly shot through the roof, causing applications to refinance existing home loans to plummet by nearly 70% since their peak in the first week of May.

For investors, the news should be interpreted as a double-edged sword. On the one hand, it's unquestionably a negative indication of the state of the economic recovery. As the central bank observed, "The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market."

On the other hand, however, virtually the entire financial industry will benefit from the -- at least temporary -- reversal of interest rates. You can see this in the reaction of mortgage REIT stocks to the news. Shares of Annaly Capital Management are up by 3.2% at the time of writing, while American Capital Agency is higher by 3.1%.

The balance sheet of both of companies, and others similarly situated, has been ravaged by the surge in mortgage rates and the concomitant decline in the value of their mortgage-backed securities portfolios. As I noted over the weekend, in the second quarter, Annaly saw its book value per share fall by 18%, while American Capital Agency's has dropped by nearly 20% since the end of last year.

For the same reason, the nation's largest lenders will likely welcome the news with open arms. This is particularly true for the biggest mortgage originators. At a recent industry conference, for instance, the chief financial officer of Wells Fargo acknowledged that its mortgage origination volume is expected to fall to roughly $80 billion in the third quarter, following seven straight $100-billion-plus quarters.

And the CFO of JPMorgan Chase noted a similar trend. "In the second quarter, we told you that if rates remained at these levels, we would expect volumes to be reduced by 30% to 40% in the second half of this year versus the first half on the back of a dramatic reduction in refinance volume," Marianne Lake said at the Barclays Global Financial Services Conference. "This is indeed ... what we're experiencing and all of Fannie, Freddie and the [Mortgage Bankers Association] agree that the volume reduction will be 35% flat."

The net result is that the financial sector -- and for that matter, homeowners -- have yet another quarter before they potentially need to worry about rates surging for the second time this year.

Will this stop the incessant financial prognosticators from confidently predicting what will happen at the next meeting? Probably not. But we can always remain hopeful.

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The article Everyone Gets It Wrong: The Fed Won't Taper originally appeared on Fool.com.

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