What is “tapering” and why does it increase interest rates?

Question of the week:  What is “tapering” and why does it increase interest rates?

Answer:  This week’s answer may get a bit wonky and in-the-weeds, but I will try to avoid both and provide a somewhat simplified response to economic principles that impact mortgage rates. For those of you well versed in the relationship between the rates, inflation, supply and demand, and the Federal Reserve’s role, or those whose eyes are already glazing over, have a good weekend!

For those who have seen “Hamilton,” or know the history, as Secretary of Treasury, Hamilton put forth a plan to have the U.S. government take on all the debt accumulated due to the revolution. This idea created a large rift amongst the states, especially opposed were Southern states that had already paid off their debt. Jefferson and Madison proposed a compromise to Hamilton to have the debt plan passed by Congress, they would support the bill, if Hamilton supported building the nation’s new Capitol in the South, on land spanning the Potomac in Virginia and Maryland. They were the ones in the room where it happened.

Hamilton’s next step was to create the Bank of the United States which would receive taxes, be the depository for government funds and make loans. This was also opposed by the South, claiming it was unconstitutional. This was one of the first big issues between those who favored a larger Federal government and those who favored more power being given to the States. In the end Hamilton got his bank, creating a very strong federal monetary and financial system that enable the nascent country to become a stronger nation on the world stage.

The Bank of the United States was chartered in 1791, it lasted until its charter was not renewed by Congress in 1811. A Second Bank of the United States was created in 1816 and lasted until President Andrew Jackson removed all federal funds in 1832 and its operations ceased when its charter expired in 1836.

In 1913 Congress established the Federal Reserve System (aka the Fed) that serves as our central bank. The purpose of the Fed is to supervise and regulate banks and financial institutions to ensure safety and stability of our monetary, banking and financial systems. In doing so the Fed is also protecting consumers and businesses.

Congress’ goals for the Fed are monetary, to maximize employment and to stabilize prices, i.e. low, stable inflation.

The primary tool the Fed uses to achieve these goals is manipulating the rates it charges banks to borrow money from the Fed to meet their reserve requirements. The Fed sets the reserve requirements (what percentage of a bank’s deposit it must have in cash each night). By altering reserve requirements and the cost to borrow funds to cover the requirements (the federal funds rate), the Fed influences the rates the banks charge their borrowers and the amount of funds they can lend. If the Fed raises the reserve requirements, and/or the federal funds rate, banks will have less money to lend and, if they lend more than their reserve requirements allow, they will charge higher rates to their customers for loans for businesses, homes, vehicles, lines of credit, etc.

Conversely if the fed funds rate is low, today it is near zero, and the Fed lowers the reserve requirements, banks have plenty of money to lend at low rates which increases the funds available for businesses to expand, or start up, and for families to obtain new homes or cars.

Historically, manipulation of the fed funds rate and reserve requirements have been the primary way the Fed controls inflation and encourages more hiring by businesses. High rates and reserve requirements restrict the flow of cash in our economy, which hurts economic growth and traditionally slows, or lowers inflation. This action also slows the expansion of labor markets and economic growth.

Low rates and reserve requirements increase the amount of cash flowing in our economy, creates economic growth and hiring, which leads to higher prices and inflation. This action is taken to prevent the economy from slowing into recession, or to help the economy come out of a recession.

As a reaction to the financial crisis in 2008, the Fed instituted what is known as “quantitative easing.” Quantitative easing (known as QE) is when the Federal Reserve purchases assets, thereby absorbing supply in the market and pushing money into the economy. The intended result is to depress interest rates, increase borrowing and stimulate economic growth and job creation.

The assets purchased by the Fed in its QE programs are bonds issued by the United States Treasury and Mortgage Backed Securities (MBS) from Fannie Mae and Freddie Mac. These are the primary financial instruments that determine interest rates in our economy, not just for government borrowing and homeowners seeking mortgages, but also bank loans, credit cards, student loans, any debt in our economy.

U.S. government debt is considered the safest investment in the global economy as the United States has never defaulted on its obligations. If you purchase as 10-year Treasury bond with a yield of 1.25% for $10,000 you will receive $62.50 every six months and in 10-years your $10,000 will be repaid to you.

Mortgage Backed Securities (MBS) are pools of mortgages that are bundled into securities and traded like bonds. The biggest issuers of MBS are Fannie Mae and Freddie Mac. Since they are long term instruments, mostly 30-year mortgages, mostly with fixed rate returns, MBS are alternative investments to U.S. Treasury bonds that have a higher rate of return.

Like any market the bond market (inclusive of mortgages) have prices that fluctuate based on supply and demand. In bonds the higher the price the lower the rate of return, i.e. interest rate; a high demand for bonds raises prices and pushes rates lower. If there is an excess of supply of bonds on the market prices drop to draw demand, for bonds lower prices mean higher rates.

What quantitative easing does is absorb all, or most, of the supply resulting in lower rates.

Because the traditional methods of stimulating the economy were completely ineffective, the Fed entered into three separate quantitative easing programs (QE-1, -2, -3) from November 2008 through October 2014. For six years the Fed purchased about $3.5 trillion in assets, pushing interest rates down and tremendously increasing the amount of cash in our economy.

When the Covid-19 pandemic resulted in shutting down many areas of our economy starting in March 2020, the Fed quickly began a new QE program (called QE-4 by some). It announced that its objective was to purchase of $80 billion in U.S. Treasuries and $40 billion in Mortgage Backed Securities with the objective of acquiring a total of $500 billion in Treasuries and $200 billion in MBS. Essentially, the idea was for QE-4 to last five to six months.

Twenty months later the Fed has purchased $1.6 trillion in Treasury debt and $800 billion in mortgage debt. As you may be aware, the economy is surging, inflation is over 5% (the Fed’s target for inflation is around 2%) and there are more job openings that applicants.

That is approximately $2.4 trillion of debt that the Fed has purchased, which has resulted in historically low rates.

It seems that the Fed’s objective of supporting and stimulating economic growth has been met. But now what?

If the Fed suddenly stopped purchasing $120 billion per month in debt there would be a tremendous drop in demand that would need to be quickly filled by investors to avoid an over supply of debt on the market and a huge and quick spike in interest rates.

The solution is for the Fed to “taper” its purchases under QE-4, slowly decreasing the amount of debt it purchases each month until the program is finished.

On Wednesday the Fed announced that it is ready to begin tapering its purchase of bonds, perhaps as soon as November. The announcement did not say how much or how fast the Fed would slow it purchases, however just the announcement that it would be slowing the amount of debt supply it would be absorbing was enough to put upward pressure on rates.

The expectation is that the tapering process will be slow and long, perhaps reducing purchases by 10% per month and take almost a year before the Fed exits the bond markets. If the taper process is too quick it can spike rates and stunt economic growth, if too slow it could result in inflation going higher and lasting longer.

Once the tapering process is complete and QE-4 is completed, the next question investors will ask is, “when will the Fed sell all the assets it accumulated as a result of quantitative easing?”

Using the results of QE’s 1-3 as an example, it is likely the Fed will not sell them, collect the interest payments and wait until the maturation of the bonds and mortgages they hold.

Prior to the Great Recession and QE-1 in 2008, the Fed had approximately $925 billion in assets on its books, in October 2014 with QE-3 was completed the Fed had almost $4.5 trillion in assets. In March 2020, before QE-4 was initiated the Fed’s assets had declined to approximately $4.2 trillion, evidence that the Fed did not actively sell off the bonds and mortgages accumulated from 2008 to 2014.

Why does this matter? If the Fed decides to reduce its balance sheet and sell the bonds and mortgages it holds it will increase supply in the market. Increased supply leads to lower prices, which results in higher interest rates.

For those wondering, the Fed currently has approximately $8.5 trillion in assets. As a comparison, the Biden Administration budget released earlier this year requests $6 trillion in spending in the 2022 fiscal year.

This will require more borrowing by the Federal government, which means more debt from the U.S. Treasury. If the Treasury is issuing more debt and the Fed is buying less debt, what impact will that have on interest rates…more supply, less demand.

For those who have stuck with this narrative, thank you. As I got started I got carried away, as I warned, into the weeds of bit.

Have a question? Ask me!

Rates for Friday September 24, 2021: After nine straight Fridays with the conforming rate not changing we see a bump in the rate, the last time the 30-year conforming was at 2.75% was all the way back in July, when I was just 58! Upward pressure on rates, as lengthily explained above.

FIXED RATE MORTGAGES AT COST OF 1.25 POINTS LOCKED FOR 45 DAYS FOR PURCHASE TRANSACTIONS:

30 year conforming                                         2.75%  Up 0.125%

30 year high-balance conforming                   3.00%  Up 0.125%

Please note that these are base rates and adjustments may be added for condominiums, refinances, credit scores, loan to value, no impound account and period rate is locked. Rates are based on 20% down with 740 FICO score for purchase mortgages.

I love this time of year, not just for the approaching fall weather, but also (or primarily?) as an all-round sports fan. I love baseball and as we approach the final week of the season many teams are under pressure to win to make the playoffs, and then…the playoffs and World Series! High school, college and professional football are underway, which comes with fans being overly optimistic, or overly pessimistic, because of how their teams have performed in the first few games. Finally, both hockey and basketball leagues are starting training camps, and every team is in first place until the pucks drop and the tip-offs are tossed.

For other golfers, we end the season with the Ryder Cup, one of favorite sporting events. I love playing match play competitions and the format of the Ryder Cup pitting the best players from the United States and Europe against each other with fans cheering is as good as it gets.

Have a great week,

Dennis

Past Weekly Rate & Market Updates can be found on my blog page at my website www.DennisCSmith.com/my-blog