MacroScope

Housing neutral for Fed doves; Operation Twist running on empty

A slightly bigger than forecast 5.7 percent rise in sales of new homes in September reported by the National Association of Realtors on Wednesday lends credibility to September’s jump in housing starts, but appears neutral for Federal Reserve monetary policy discussions.

The jump in new home sales seems to have largely justified the 11 percent jump in September housing starts, says Decision Economics senior economist Pierre Ellis. The inventory of houses for sale at the end of September rose just 1.4 percent, from the end of August and the months’ supply fell to 4.5 months from 4.7 months, he added.

Thus, the increased production of houses seems not to have involved any “over-exuberant optimism” – and the impact if demand were suddenly to evaporate would be contained, he said. “Healthy skepticism seems to prevail in builderland,” Ellis observes.

The home sales jump should leave doves on the Federal Reserve’s policy-making committee feeling justified in their QE3 push since the doves see the third phase of unconventional easing “as a measure to sustain and further strengthen housing demand,” Ellis said. But the sales increase gives Fed doves no new evidence with which to argue QE3 should be stepped up immediately, he said.

Ellis said “odds do favor” a continuation of Operation Twist, a monetary easing tool that involves the Federal Reserve selling instruments that will mature in three years or less and using the proceeds of those sales to buy longer maturities. That program is currently set to end in December.

What the Fed twisteth, Treasury issueth away

So much for policy coordination. Just days after the Treasury published a note touting its progress in lengthening the average maturity of its outstanding bonds, the Fed decided to extend Operation Twist – a policy aimed at doing the exact opposite. By selling an additional $267 billion in short-dated bonds to buy long-term ones, the Fed is trying to take Treasuries with longer maturities out of the market, to lower yields and entice investors to take on more risk.

In a narrow sense, the Treasury’s approach is perfectly reasonable: U.S. interest rates are at historic lows, so it stands to reason that the government should lock in that low cost of borrowing for the longest period possible. However, in the context of an economy that remains exceedingly weak – and where the only source of stimulus appears to be a reluctant central bank – the move could be viewed as somewhat incongruous.

Fed Chairman Ben Bernanke himself addressed the issue when he was asked during the post-meeting press conference whether it would make sense for the U.S. government to issue more longer-term bonds given the current low-rate environment.

As financial conditions tighten, Fed may have to run to stay in place

Seemingly lost in the talk about whether or not the Federal Reserve should ease again is the idea that financial conditions have tightened and the U.S. central bank may have to offer additional stimulus if only to offset that tightening. Writes Goldman Sachs economist Jan Hatzius:

Alongside the slowdown in the real economy, financial conditions have tightened. Our revamped GS Financial Conditions Index has climbed by nearly 50 basis points since March, as credit spreads have widened, equity prices have fallen, and the U.S. dollar has appreciated.

Goldman’s new GS Financial Conditions Index is based on the firm’s simulations with a modified version of the Fed’s FRB/US Model. It includes credit spreads and housing prices and has a closer relationship with subsequent GDP growth than the previous version of the index, the firm says. A 100-basis-point shock to the GSFCI shaves 1-1/5 percent from real GDP growth over the following year. Still, it’s not quite as bad as it sounds:

Uncomfortably political

Four leading Republicans wrote to Federal Reserve Chairman Ben Bernanke before the Fed’s Sept. 20-21 policy meeting recommending the Fed stop taking steps to boost growth. Fed interventions to pull down the high unemployment rate may do more harm than good and risk inflation, the officials said.

The Fed to some extent brushed those objections aside, deciding at the end of the meeting that a deteriorating outlook warranted buying and selling $400 billion worth of Treasuries to shift its holdings to longer maturities. Doing so should push down longer interest rates and may promote mortgage refinancing, Fed officials hope.

While the Fed would likely argue that its action was not the same as expanding its balance sheet through outright bond buying – which many critics objected to – it was nevertheless taking an active step, and could draw criticism from Republican lawmakers and candidates for the presidency. How could Congress make life miserable for the Fed? Lawmakers of both parties have proposed measures that would diminish or alter the Fed’s role.

Fed dips back into housing finance

While financial markets are primarily focused on “Operation Twist,” the Fed’s return to buying mortgage-backed securities has helped that market. MBS have outperformed Treasuries and interest rate swaps since the FOMC announcement.

This has yet to translate into much of a drop in mortgage rates for consumers, however. And even if it does, many economists doubt lower mortgage rates can do much to boost home sales and refinancing, helping to put more cash in consumers’ pockets. Banks are reluctant to lend for a variety of reasons, while consumers are reluctant to borrow due to worries about their jobs and the poor outlook for the economy. Homeowners with underwater mortgages remain unable to refinance their loans — barring a sudden improvement in the market or some type of relief from Washington.

As of early Thursday, the current coupon 30-year MBS were 10 basis points tighter in spread versus Treasuries after a 15 basis points tightening on Wednesday, but the average 30-year mortgage rate is down only 3 basis points overnight to 4.10 percent (albeit a record low) according to Bankrate.com.

The Fed goes long

As the U.S. economic recovery stumbles, most observers Federal Reserve policy expect the central bank next week to announce an initiative to replace shorter-term securities on its balance sheet with longer-term ones in a bid to drive longer-term interest rates lower.

Fed watchers call the maneuver Operation Twist after a like-named Cold War-era initiative in which the Fed bought longer term securities with a similar objective.

A twist action could stimulate mortgage refinancing and push investors to invest in corporate bonds, which could spur business borrowing, or in equities, which might help stocks recover, the Fed believes. By adjusting the composition of its portfolio rather than launching an aggressive new round of bond buying, also known as quantitative easing, the Fed would be taking a relatively modest easing step, but be acting all the same.

Doing the Twist, and other Fed tools

For markets, it’s a fait accompli: the Federal Reserve, which meets on Tuesday and Wednesday, is expected to push for some variation on a 1961 policy, known as Operation Twist because it aims to push down long-term borrowing costs while nudging short-term rates higher. Primary dealer banks polled by Reuters two weeks ago, just after the Labor Department reported the U.S. job market had stagnated in August, saw an 80 percent chance that some of sort of twist-like measure would be put into place.

Still, there are a number of variants the Fed could employ:

Half Twist: The most modest, perhaps too weak given market fragility, would be to direct proceeds from existing bonds on the balance sheet into longer-dated Treasury securities.

Full Twist: A more aggressive approach would involve active sales of short-dated bills and longer bond buys, and attempt to flatten the yield curve to effectively force investors to take more risk by lending at longer maturities. A February paper from the San Francisco Fed argued that, unlike the conventional wisdom that the original Operation Twist was a failure, the measure actually drove down long term Treasury yields by what the study calls a “highly statistically significant” 0.15 percentage point.