Wednesday, March 31, 2010

Fed MBS Purchase Program Ends Today

Today marks the end of the Fed's $1.25 trillion agency MBS buying spree. The program contributed to reviving the mostly dead housing market by keeping mortgage interest rates low so home buyers could afford their mortgage payments. A zero fed funds target didn't hurt either. It's like the Fed acted as the anesthesiologist, while Drs. Fannie, Freddie and FHA argued over how to correctly perform the quadruple bypass, with the Treasury occasionally running in with a crash cart, shouting "Clear!" and introducing another homeowner tax credit.

The Fed's attempts to boost the housing market had other side affects as well. Today's WSJ has a front page story on the monster rally in bonds since October 2008. Junk bonds, in particular, have outperformed nearly every asset class since the lows in the market. By buying over one trillion in MBS and another $250 billion in Treasuries, the Fed gobbled up a significant amount of supply from bond market investors who had nowhere else to go with the $375 billion in inflows that their funds received in 2009.

So now what? Pundits far and wide are arguing over what will happen to interest rates once the Fed is out of the picture. My two cents is that the long end absolutely has to go higher. It's just simple economics. A huge portion of the demand has been removed and who will replace it? Bulls keep arguing that zero interest rates for an "extended period of time" will continue to stoke demand for higher-yielding assets. But does anyone really know the Fed's exact definition of "extended period"? Sometimes my three-month-old spends nearly 30 minutes in her swing, a time period which she refers to as "an extended period." The Fed can turn on a dime if it needs to. Particularly if the FT's front page stories go from today's "Steel Prices Set To Soar" to "Holy Cow! Steel Prices are Surging" tomorrow.

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