Rates Ease as Fed Says it Will Slow Pace of Balance Sheet Tightening

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Mortgage rates looked poised to drop Wednesday after Federal Reserve policymakers said they’ll slow the pace of “quantitative tightening” — an unwinding of the central bank’s $7 trillion balance sheet that’s helped keep rates elevated — to less than half the pace envisioned two years ago.

At its latest meeting, the Fed left the short-term federal funds rates unchanged at its current target of 5.25 percent to 5.5 percent, as expected.

But following through on guidance Fed Chair Jerome Powell provided in March, on June 1 the Fed will slow the pace at which it trims its holdings of long-term Treasurys by $35 billion a month.

Because the Fed hasn’t been able to hit its targets for reducing its holdings of mortgage-backed securities (MBS), the Fed’s balance sheet easing will soon total only $40 billion a month — less than half of the $95 billion target set by policymakers in 2022.

“The decision to slow the pace of runoff does not mean that our balance sheet will ultimately shrink by less than it would otherwise, but rather allows us to approach its ultimate level more gradually,” Powell said at a press conference following the Fed’s latest meeting.

“In particular, slowing the pace of runoff will help ensure a smooth transition, reducing the possibility that money markets experience stress, and thereby facilitating the ongoing decline in our securities holdings that are consistent with reaching the appropriate level of ample reserves.”

10-year Treasury yields retreat from 2024 highs

Source: Yahoo Finance.

Yields on 10-year Treasury notes, which are a useful barometer of where mortgage rates are headed next, dropped nine basis points Wednesday, to 4.59 percent, a 15-basis-point decline from the 2024 high of 4.74 registered on April 25.

But Marty Green, principal at mortgage law firm Polunsky Beitel Green, noted that the odds of Fed rate cuts this year appear to be dwindling.

Marty Green

“With inflation data continuing to show a bumpy road toward the Fed’s 2 percent inflation target, it isn’t surprising that the Fed chose to leave interest rates unchanged and is delaying the prospect of interest rate cuts until later this year,” Green said in a statement.

“The question now is whether inflation proves to be so sticky that the Fed decides that rate cuts in 2024 are no longer in the cards and will instead be delayed into 2025.”

The CME FedWatch Tool, which tracks futures markets to predict the odds of future Fed moves, on Wednesday puts the odds of the Fed making more than one rate cut this year at just 42 percent, down from 85 percent on April 1.

Green characterized the Fed’s decision to scale back the pace of balance sheet tightening as “good news.”

“Over time, this adjustment should have some positive impact on interest rates without the Fed needing to adjust the Fed funds rate,” Green said.

Fed to slow pace of ‘quantitative tightening’

Source: Board of Governors of the Federal Reserve System, Federal Reserve Bank of St. Louis.

While the Fed has tight control over short-term interest rates, long-term interest rates on government debt and MBS are driven by supply and investor demand.

To keep the economy from imploding during the pandemic, the Fed not only brought short-term interest rates down to 0 percent but was buying $120 billion in debt every month — $80 billion in long-term Treasury notes and $40 billion in MBS.

As its balance sheet neared $9 trillion, the Fed reversed course on “quantitative easing” and instituted “quantitative tightening” as part of its efforts to fight inflation.

In 2022, the Fed ramped up “quantitative tightening” with a goal of trimming $60 million in Treasurys and $35 billion in MBS from its balance sheet each month. Instead of replacing $95 billion in maturing assets to maintain the status quo, the Fed would let those assets roll off its books.

Now, instead of letting $60 billion in government debt roll of the books every month, the Fed has set a new cap on Treasury redemptions at $25 billion a month.

Although the Fed is leaving the $35 billion runoff cap on MBS in place, it’s been unable to hit that target. Because elevated mortgage rates have slowed the pace at which borrowers refinance their mortgages, the Fed has only been able to trim its mortgage holdings by $15 billion a month for some time.

Asked if there was a contradiction in the Fed holding short-term rates steady to try to cool the economy while reducing the pace of quantitative tightening, Powell said that rates are “the active tool of monetary policy.”

Fed policymakers are tapering the pace of quantitative tightening to avoid the kind of disruption that money markets experienced the last time it tried to trim its balance sheet in 2019, he said.

“This is a plan we’ve long had in place … not in order to provide accommodation to the economy or to be less restrictive to the economy,” Powell said. “Really it’s to ensure that the process of shrinking the balance sheet down to where we want to get it is a smooth one, and doesn’t wind up with financial market turmoil the way it did the last time the last time we did this — and the only other time we’ve ever done this.”

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Email Matt Carter