Is QE3 Working?

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With the election and now the Fiscal Cliff taking over most of the headlines the past few weeks, it’s easy to forget that the Federal Reserve is still in the midst of their efforts to boost the economy.  The latest round of easing, termed QE3, was launched about two months ago. Let’s take a look at how it has affected mortgage rates and Treasury yields.

First, some background.  On September 13th, the Fed announced that as part of its effort to keep rates low until mid-2015, it would implement QE3 and buy $40 billion of agency mortgage-backed securities each month.  These purchases are in addition to the $45 billion a month of long-dated Treasuries that the Fed is buying as part of the Operation Twist program, which is scheduled to continue until the end of December. In contrast, QE3 has an indefinite end date; it will be terminated when the Fed believes it has effectively boosted employment.

In the initial weeks after QE3 was announced, the 30-year fixed-rate mortgage rate did drop 33 basis points from 3.86% to 3.53%, according to the Mortgage Bankers Association.  However, after the initial drop rates leveled off at 3.52% as of November 13th, despite the prospect of continued Fed purchases.  Meanwhile, the 10-year Treasury remained more or less flat, raising questions of whether QE really works.

There are a couple of things investors should keep in mind.  First, the market had anticipated QE3 long before it was officially announced.  A look through news archives shows that in January 2012, Bernanke stated that housing market weakness was a significant barrier to growth, leading to speculation that future easing could focus on MBS. The Fed first extended Operation Twist in June, before following up with QE3 on September 13th.

Second, the Fed can influence long-term borrowing rates but not set them. The Fed does set the Fed Funds Target rate, a short-term rate that banks can borrow from the Federal Reserve.  But the Fed cannot directly set rates on Treasuries, mortgages, municipal or corporate bonds. What it can do is embark on purchase programs such as QE3 in an effort to push up bond prices and push down yields.  Ultimately the Fed is just one (albeit large) player in the market, while rates are determined by the supply and demand dynamics of all investors.

While the multiple rounds of quantitative easing have increased the demand for Treasuries and MBS resulting in higher prices and lower yields, other market forces will ultimately determine the level and rate of change of these rates.  For example, after the start of QE2 in November 2010, the US 10-year actually rose from 2.62% to 3.73% by February of 2011. Fed action had encouraged risk-seeking behavior from investors, pushing them into riskier asset classes and out of less risky investments like Treasuries. Less demand for Treasuries during this time period caused rates to rise despite the Fed

purchases.  When considering the impact of Fed actions on markets, it is important for investors to realize that other investors’ actions will have a significant impact on how interest rates are affected.

Finally, the impact of QE3 has been to push mortgage rates lower, though most of the decline was driven by concurrent declines in Treasury rates. If we consider that the market probably began pricing in QE3 from March 2012, the 30-year mortgage has dropped from a high point of 4.19% to its current level of 3.52%, a drop of 56 basis points. Over the same time period the 10-year Treasury dropped from 2.02% to 1.69%, a decline of 33 basis points. Mortgage investments generally kept up with Treasury investments over the period.  The Barclays U.S. MBS Index returned 1.85% on a total return basis, from 3/1/12 to 10/31/12.

What does all this mean for investors? First, my advice is to stay informed about Fed policy and direction, as it impacts every investor in the market.  Second, understand that the end impact of Fed policy isn’t always as clear as it may at first seem, there are a lot of other factors that contribute to the eventual direction of interest rates and asset class returns.  Third, remember that diversification can be an investor’s best friend, as it can help a portfolio weather uncertainty, no matter which direction the Fed heads next.

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