The end is near—at least for the Federal Reserve’s asset purchase program known as quantitative easing. The Fed has used this tool to purchase $40 billion in mortgagebacked securities and $45 billion in longer-term Treasury securities each month since December 2012.
These purchases put downward pressure on long-term interest rates, including mortgage rates. After a much-anticipated June 19 Federal Open Market Committee statement, however, the bond market sold off due to expectations that the Fed would begin tapering its asset purchase program later this year and end the program in mid- 2014, when the unemployment rate is expected to fall below 7%.
As a result, investors’ demand for longer-term bonds has declined, pushing up interest rates. After reaching a low of 1.66% on May 1, the 10-year Treasury interest rate rose more than 50 basis points (bp) in little over a month to reach 2.22% on June 10. It rose another 23 bp, to 2.45%, in the 24 hours after the Fed announcement on June 19.
This rise in nominal interest rates is due to rising real interest rates, not rising inflation expectations. Inflation expectations have fallen 40 bp since the first quarter (“Interest rates and inflation expectations”).
Real interest rates have been in negative territory since December 2011, indicating investors were losing money in the sense that their annual nominal return was less than the annual expected rate of inflation over the next 10 years.
Negative real interest rates during the last year and a half also reflected the Fed’s highly accommodative monetary policy. But ever since the Fed began signaling quantitative easing was nearing its end, real interest rates have shot up by more than 95 bp, effectively tightening monetary policy.
This already has affected the mortgage market. The Mortgage Bankers Association reports that mortgage refinance activity fell 30% from mid-May to mid-June, as the contract rate for the 30-year, fixedrate conforming mortgages rose 39 bp. But purchase mortgage activity should improve as the housing market recovery continues.
We expect the 10-year Treasury interest rate to rise to 2.5% by the end of 2013 and 3% by the end of 2014, as real interest rates rise faster than expected inflation falls. This will steepen the yield curve, reducing the margin compression financial institutions have experienced over the last several years.
New mortgages will have higher yields than what we’ve seen during the past couple of years, slowing the fall in asset yields that credit unions have seen during the past six years.
On the downside, the mortgage refinance boom will end, reducing earnings as credit unions see less mortgage origination fees and less “gains on sale of mortgage” income.
John Maynard Keynes wrote that “the rate of interest is the reward for parting with liquidity for a specified period.” Well, that “reward” is moving up, at least for longer periods as the market anticipates the change in Fed monetary policy.