Yes, Quantitative Easing Helps Mortgage Rates, But There's a Catch

From Mortgage News Daily:

Two Federal Reserve System economists have looked at the recent quantitative easing programs of the Federal Reserve to determine whether a central bank's monetary policy could retain potency when short-term rates reach zero.  The two, Diana Hancock and Wayne Passmore, were testing their theory that because the banks could purchase a wide variety of assets, not just short-term government securities the purchases could be used to enforce explicit ceilings for yields on longer-term securities, including longer-dated Treasury securities, agency debt, or agency mortgage-backed securities  

If such a long-term asset purchase program were successful they say, not only would yields on such securities fall, but yields on private debt (such as mortgages) would probably fall as well and the increase in the monetary base would lead to an increase in asset prices in general and a subsequent impact on spending.  Thus, even a central bank whose accustomed policy rate has been forced down to zero would not "run out of ammunition."

To test these assumptions they two looked at the impact the Fed's large-sale asset purchases (LSAPs) or quantitative easing (QE) programs had on agency mortgage-backed security (MBS) yields and thus on conforming mortgage interest rates.  They selected periods when the financial markets were functioning well rather than being in turmoil because the prevailing view is that LSAP's would have no effects on asset prices in normal times.  They tested the countervailing opinion is that such purchases can potentially influence all components of MBS yields to some extent by (1) signaling Federal Reserve intentions to financial markets (2) portfolio rebalancing effects, and (3) liquidity effects.  

The purchase of long-term assets may make more credible the Feds commitment to keep interest rates low even after the economy recovers, particularly if the central bank weighs potential losses on its asset holdings in its objective function.  This signaling affects all bond market interest rates, since lower future federal funds rates can be expected to affect all interest rates.  And, as market participants anticipate the announcement of LSAPs, their effects can be reflected in market prices even before they are announced.

These purchases can also potentially affect MBS yields through a portfolio rebalancing channel where the Fed purchases reduce private sector holdings while increasing short-term, risk-free, private sector bank deposits.   The private sector finds it holds more of these deposits than they desire because of receipts from selling securities so they bid up prices of remaining long-term securities and thus lower the yields.  This "scarcity" effect is primarily focused on the current coupon yield MBS.

For longer-term securities, this portfolio rebalancing effect is often expected from duration and convexity risk.  Duration refers to the length of time that the bonds will likely provide an income stream.  Convexity refers to "duration's sensitivity to rates"--i.e. a pool of mortgages that might normally last for about 7 years could quickly change to lasting half that time if rates fall quickly enough, prompting more refinances out of that pool....MORE