Time to put the Toothpaste Back in the Tube
Since the lockdowns that started in March of last year, the Federal Reserve has bought close to $1 trillion of mortgage-back securities, and only now appears to be noticing that the resulting low mortgage rates have led to a near 25% increase in median home prices year over year (for the month of May). Coupled with an additional $2.8 trillion of Treasury purchases over the same time frame, the Fed appears conflicted on how to start unwinding this trade, as well as unsure of the market’s expectations for the unwind.
Both mortgage and Treasury purchases have had the effect of pushing and keeping long term lending rates lower, as they have forced investors into alternative risky assets (from investment grade bonds, to municipal bonds all the way to high yield bonds and equities). While it appears the Fed would like to taper the mortgage purchases ahead of any slowdown of Treasury purchases, it seems Fed officials are afraid of the impact of such a move on corporate spreads, making risk-based borrowing relatively more expensive – i.e. widening credit spreads. This could spook credit markets, with a spillover on equities. Furthermore, with the Fed being the primary financing arm of the US Government, such a preference for Treasurys over mortgages could allow critics to charge the “independent” Fed of aiding and abetting the funding of massive deficit spending for political purposes.
This quandary is at the Fed’s own making, having supported credit markets well beyond what was necessary during the pandemic-induced economic contraction. Now, with another multi-trillion infrastructure spending program likely to pass into law we are bracing for the Fed’s next move.