Higher Interest Rates Expected from End of Fed Bond Buying

Mortgage rates and other long-term interest rates are bound to rise measurably in the second half of this year, if not earlier.  The Federal Reserve has been aggressive in buying U.S. government bonds as part of Quantitative Easing and has tried to hold down the long-term rates with Operation Twist.  But both measures will soon be coming to an end.  Furthermore, there will inevitably be a reversal of these policies at some point, which means the Federal Reserve will be selling back the bonds it had already purchased and sitting on the balance sheet, probably at the same time the U.S. government will continue to sell its bonds to cover the deficit spending.  That means someone has to buy the flood of U.S. government bonds.  If there is a lack of investors, then higher interest rates will be required to induce buyers to step forward.  Higher offered interest rates also mean higher mortgage rates as well.

A quick review of recent history will help better understand why rates will move higher.  In the aftermath of the financial market crisis from 2008 the Federal Reserve purchased roughly $1.6 trillion in U.S. government debt.  Without this purchase, the interest rates would have been higher since relying on purchases solely from private bond investors and foreign governments such as China and Saudi Arabia would have been insufficient.  The U.S. Federal Reserve in essence printed money to hand over $1.6 trillion to the U.S. Treasury to meet its borrowing needs.  At the time, inflation was not an issue and if anything there was a growing concern over future deflation, a period of falling consumer prices.  The buying of government debt by the Federal Reserve was known as Quantitative Easing.  Two rounds were pursued, thereby giving the name QE1 and QE2.  A third round appears out of the question because the economy is healing and growing, and with inflation above the Fed’s preferred rate of 2 percent.

In addition to Quantitative Easing, the Federal Reserve implemented something known as Operation Twist.  The goal for this (given some harsh critics, like the Presidential candidate Ron Paul, who have accused the Federal Reserve of printing too much money), was to not to print money, but simply to re-shift the type of bonds that the Federal Reserve would hold.  The Fed sold off some of its short-term U.S. Treasury bills it already had in its balance sheet to the market and thereby took in cold hard cash already in circulation (not freshly printed ones).  It then used this cash to buy long-term U.S. Treasury bonds of 10 and 30 years in length, thereby recirculating this cash back into the market.  So the total amount of the cash remained the same from the broader economy point of view but the composition of type of bonds held by the Federal Reserve was towards longer-term bonds and away from shorter-terms ones  In essence, this helped push down the long-term bond yields.  Automatically, this pushed down the 30-year fixed rate mortgages.

But these measures of Quantitative Easing and Operation Twist are coming to an end in a couple of months.  The bottom line being who will now buy incoming the long-term government debt.  After all, the U.S. is running a very high budget deficit and needs to continue to borrow heavily for the foreseeable future.  In addition, the Federal Reserve may need to unwind what it did (by selling off government bonds it had purchased) if inflation picks up.  Even more government bonds will need to be absorbed.  Very hard to see how this can be done without offering higher interest rates.

The average 30-year fixed rate mortgage is around 4.0 percent today.  It will rise to 4.4 percent by December.  It will then reach 5.2 percent by the end of 2013.  This projection is being done with fingers crossed that it will not be even higher.