In The World of Rates, What Goes Down Must Come up; Expect Higher 10Y and Mortgage Rates

Next week the Fed will cease purchasing agency MBS, to an industry outsider this innocuous sounding fact may not garner much attention, but the reality is the implications are likely very significant, and are already making themselves apparent in the market.  Former Fed Chairman Alan Greenspan recently referred to last week’s jump in U.S. interest rates as a ‘canary in a mine’ towards further increments in the future.  Mr. Greenspan’s fears stem from the federal government’s massive–unprecedented–deficit, which is not a U.S. exclusive phenomena.  Outside of the U.S. I expect pressure will be put on rates from the U.K. to Japan, with Japan (debt to GDP approaching 200%) being the most susceptible to a loss in investor confidence over the short-term as it rolls over a significant amount of debt on a very near-term basis.

But, I digress back to the Fed.  Since the start of 2009 the Fed has begun purchasing up to $1.25trn of Agency MBS securities, these purchases have helped keep interest rates low and combined with the first time home buyer tax credit stoked pretty solid gains in home sales through November of 2009.  However, since then an extension to the first time home buyer tax credit has proved itself impotent in stirring new demand, and next week as the Fed stops purchasing MBS, mortgage rates will likely continue on last week’s upward trajectory, putting any housing recovery into further jeopardy.  To help show the correlation between mortgage rates and the Fed’s MBS purchases I created the chart below.  The chart shows the 4wk moving average of the net change of the Fed’s MBS position, overlaid with 30Y mortgage rights:

As the chart demonstrates, when the Fed’s purchases of MBS goes up, rates go down; and as their purchases go down rates generally go up.  I continue to expect that as a result of the termination of the Fed’s MBS purchase program 30Y mortgage rates will likely rise anywhere in the vicinity of 25 to 50 basis points, which could be further exacerbated by rising treasury yields.  Rising rates will put further strains on a stalling housing recovery, and may force the Fed to reinitialize the program, or come up with another means of supporting the real estate sector.  However, as I mentioned in the beginning of this entry, the bigger story over the months ahead could lie in U.S. and international rates markets, where risks may not be properly priced in given weakening fundamentals, partially due to Keynesian policy responses to the recent crisis.  On that note, I expect we will see 10Y treasuries yielding above 4% (to as high as 4.5%) over the short-term, and as for Japan and some of the other troubled European nations, beware.