Why the Fed Won’t Raise Rates until 2012

by JT McGee

There’s plenty of talk about central bank activity–commodities, namely food and energy, are surging, and the price of money hasn’t been this low since…well, forever. The Federal Reserve claims it has a dual mandate to keep the value of the dollar firm, and the level of unemployment low.

Monetary policy isn’t that difficult to understand—when there is action, there’s usually some reason for it that is easily discovered. I submit to you my own view of why the Fed is dickering with the money supply: to keep people in their mortgages.

Below is a chart with monthly mortgage resets by category, which can be mostly be interpreted also as by credit quality:

fed, rate hike, QE2, QE3, bond buying, mortgage resets

I’ll define each:

Option adjustable rate – Also known as “option ARMs,” these loans are issued in much the same way as a line of credit. The borrower has the option to pay a minimum payment, a payment equal to only the interest, and both 15-year and 30-year payments. These are the mortgages of the housing boom, because they were written with the idea that housing/incomes only go up. You could effectively pay less on your option ARM than the interest that accrues each month, essentially building more and more negative equity with each payment. Each one of these option ARMs that reset this year and last will take on the current mortgage rate for the rest of the loan term. (Basically, rates need to be low or these borrowers are going to see serious value in defaulting.)

Subprime – Loans made to people who couldn’t possibly afford to pay them, but with the understanding that, again, houses and incomes only go up in value. Once repackaged, companies like AIG would issue credit default swaps against these mortgages, essentially saying they’d pay if the borrower didn’t. Neither paid—go figure!

Alt-A – These are basically not as bad as subprime, but still not prime, either. Low credit scores, no-documentation loans (referred to also as NINJA loans for No Income, No Job, No Assets), and/or mostly loans issued for purposes of speculation. Garbage, sure, but not nearly as bad as Subprime…at least we think!

Prime – Good debt to income ratios, healthy incomes, and excellent credit scores make up the prime category. You’ll notice there wasn’t much prime activity during the bubble…mostly because these people already owned a home, or realized that homes were far too pricy to buy.

Agency – Debt that qualifies for purchase by government-sponsored entities Fannie Mae and Freddie Mac and often part of the FHA loan program.

Quantitative Easing I & II

At the height of the financial crisis, the Federal Reserve authorized a quantitative easing program for $1.25 trillion that would enable it to purchase $750 billion in mortgage-backed securities, and as much as $500 billion in US Treasuries.

Most of this money was intended to create liquidity by covering up the bulk of the nearly $1 trillion in subprime mortgages that were to be reset at a much higher rate in 2007-2009. Then, just two years later, the Fed authorized another $600 bond buying program that would seek to purchase long-dated Treasuries to keep rates low. This program, now known as quantitative easing 2, or QE2 for short, is anticipated to continue through June, at which point the Fed will exhaust its $600 billion fund created for the buying program.

This year alone, some $400 billion worth of loans will be forced to reset from the interest rate of the date of issue. Ben Bernanke has made it evident that he is very much interested in the status of the real estate market, and given his favor toward keeping rates low, I can’t see him pushing rates higher any time soon.

2012 federal reserve rate hike, refinance

My Own Forecast

  • QE 2 Ends with no replacement – Quantitative easing round two will end this summer, with no plans to continue it.
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  • Fed stops reinvesting maturing debt – In between QE1 and QE2, the Federal Reserve decided it would allow maturing debt to retire, thus shrinking its balance sheet. It later reversed that decision and enacted QE2. This time, I see the Fed allowing maturing debt to mature. In doing so, it will receive cash from the treasury/MBS debt obligations it owns, reducing the money supply (though not to pre-QE levels) and pushing rates up based on simple supply-demand.
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  • Fed hikes in late fall 2011, at the earliest – Any rate hike will have to come after the Fed starts selling its MBS/Treasury holdings, or allows them to mature. I see a rate hike as Bernanke’s best tool for telling people that they better refinance RIGHT NOW and not a moment later.
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  • Another hike in spring – The Fed will probably hike for a second time in spring 2012, mostly for the purposes of winding down its balance sheet and cooling off inflation fears.

Variables at play

 

  1. Oil/Energy prices – The rise in food and energy prices couldn’t happen at a worse time. Poor crop yields last year combined with fears of supply shocks in energy due to Middle Eastern politics has sent both commodities higher. Unfortunately, no relief will be found in food until we know the result of this year’s summer growing season. Traditionally, April futures are priced for the worst possible crop yields, so hopefully a healthy summer harvest does help cool rising food prices. As for oil, the sky is still the limit, I’m afraid.
  2.  

  3. Jobs – Yeah, how couldn’t you include this?
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  5. Government Spending – If the 2012 Federal Budget does come in low—and I mean seriously low—then the debt markets will see lower supply-to-demand ratios, and the Fed would then be able to offload more of its Treasury/Mortgage-backed-securities holdings. I give this possibility a snowball’s chance in hell.
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  7. Home Prices – If Bernanke can convince everyone who hasn’t jumped ship to stay in their home, we avert major crisis in having more supply thrown on top of the already growing “shadow inventory” that the banks are holding off the market.

{ 6 comments… read them below or add one }

Ravi Gupta April 11, 2011 at 08:27

Great post! I think you’re right about the rate hikes and he’s said as much during one of his addresses to congress. It will be interesting to see how this plays out and if your predictions come true.

-Ravi Gupta

Reply

JT McGee April 12, 2011 at 02:05

@ Ravi – Something has to give. I can absolutely understand their concern in letting these mortgages reset at lower rates, they’re definitely pushing some buttons with very low rates. Bill Gross cut Treasury exposure to net-short in March–not a good signal!

Reply

LaTisha @FSYAonline April 17, 2011 at 13:23

Solid reasoning. A rate hike would be nice especially since it would signal a healthier economy to many investors. Canada decided not to raise rates yet (which sucked for me since I’m short USD/CAD, still hoping for the drop…) but the trend of rate hikes seems to be catching steam. If we see the Bank of England finally raise rates I’d have to say that we are officially out of the great recession.

Reply

JT McGee April 24, 2011 at 17:00

@ LaTisha – I think a rate hike would definitely do a lot to calm fears, but it will absolutely have to come with economic growth/growth in Federal revenues. Any uptick in rates will have a negative effect on how much we pay in debt service, so there needs to be some agreement with the Federal Reserve and congress.

Reply

Travis@TradeTechSports May 6, 2011 at 01:44

I think the housing market is still a big concern. The shadow inventory isn’t going away anytime soon and if you add some inflation on top if that and now you may have some real concerns. Raising rates may be the answer but could also be a double edged sword surpressing housing sales further.

Reply

Steve May 29, 2011 at 22:57

I agree with your assumptions. March 2012 will probably be interest rate hikes.

Reply

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