By Warren Kirshenbaum
The Federal Reserve's plan to purchase $600BN in US Treasuries has wide ranging consequences, including the devaluing effect that the influx of such a large amount of dollars will have on the dollar itself. A devalued dollar makes US produced goods cheaper, causing exports to rise. As a deficit nation, the US benefits from an increase in exports, but it comes at the expense of other countries. Therefore, this plan has been roundly criticized by many countries who claim that the US is manipulating its currency, and as the issuer of a global reserve currency such as the dollar the US has a responsibility to keep the dollar fairly valued. It is certainly an interesting position for currency manipulating countries like China to take, but nonetheless this is the position they are taking, and as we will discuss below their influence on our domestic interest rate environment is significant.
So, what effect will the Fed plan have on mortgage rates? As the Federal Reserve's monetary policy has been to keep the Federal Funds rate at less than 1% for some time now, long term interest rates have remained low. Mortgages are generally priced off the 30 year Treasury bond, which is currently yielding 4.25%. Average 30 year fixed mortgages are pricing at 4.625%. In that a bond's yield increases as the price of the bond decreases, if the prices of US Treasuries decline, then yields will increase. Bond prices have been trending higher for several days now on concerns of inflation and uncertainty about the Fed's plan to buy treasuries.
So let us analyze this situation. As a deficit nation, we spend more than we receive. The only way to sustain such behavior is to borrow funds to finance the shortfall. Many nations have large stockpiles of US dollars from trading with us, and many more hold their reserves in dollar denominated assets. These dollars need to be put to work, and the value of dollar denominated assets need to remain steady for these countries to continue to run surpluses which are need to finance their economic growth, provide infrastructure and provide basic services for its citizenry. Therefore, there are a large number of countries buying US debt in the form of US treasuries. If other countries, like China decide that the US economy is shaky and they reduce their purchases of treasuries, or even begin to sell off the treasuries they currently own, bond prices would fall and yields will increase. That would mean that other countries would be unwilling to finance our debt at the same levels as they have been. In that case, with the Fed itself buying US treasuries, there will not be an excess supply of treasuries, which will keep their prices steady, or even cause an increase in bond prices. It would appear, however, that if we were in a deficit to begin with, the only way the Fed could buy treasuries would be to print more money to do so, which will improve the cash position of the US but deflate the dollar, and obligate us to greater borrowing costs. An increase in the US cash position, together with an increase in exports could have a formidable effect on our current account surplus and reduce our deficit, but clearly we are devaluing the dollar and annoying our trading partners whose point is well taken. They say that the US should be able to increase its exports by improving its competitiveness not devaluing its currency. Nevertheless, this seems to be a short term plan on the part of the Fed. Basically, increased export production can lead to the creation of jobs, and a lowering of the unemployment rate, which leads to a rise in consumer confidence. Mortgage rates and other borrowing costs could increase, which would lead to manufacturing price increases and, therefore, an increase in the prices of consumer goods, i.e. inflation.
So we are trading deficit reduction and job creation for inflation and higher borrowing costs. What all of this will do for our businesses and economic outlook is anyone's guess, but it is certainly shaping up to be a challenging time period.