For the last several years, the Federal Reserve has pursued an unorthodox (read “last resort”) fiscal policy known as “Quantitative Easing.” Fed Chair Ben Bernanke had originally stated that QE would continue until unemployment fell to 6.5%. Even though we are not there yet, and likely won’t be for a while, in May, Mr. Bernanke gave an indication that he might take his foot off the QE pedal a little sooner than expected. The credit markets and stock markets went crazy. To understand why, we need to understand: (a) What QE is all about; (b) How it affects stocks and interest rates; and (c) What will be the effect when QE is discontinued.
What Is QE? It is a policy whereby the Fed purchases large quantities of long-term securities from big banks. The Fed prints money to make these asset purchases. The goal is to keep long term interest rates low and release more money into the market place, thereby increasing the money supply. Currently, the Fed is buying $45 billion in treasury bills (“T-Bills”) and $40 billion of mortgage-backed securities a month. When interest rates went down – which they did – the hope was that the construction and housing industries would rebound, businesses would increase capital investment, and employment would increase. For a cynical, but very funny explanation of Quantitative Easing, see cartoon here.
As we know, interest rates today are at historic lows, and the big banks, who sold the Fed treasuries, are awash in cash. Unfortunately, although QE may have produced some incremental benefits, on the whole, it has been underwhelming. In fact, today the Fed is taking its third run at QE, called “QE3”. QE1 occurred shortly after the credit markets crashed following the Bear Stearns collapse and the Lehman bankruptcy in the fall of 2008. QE2 occurred in 2010; QE3 was initiated in 2011.
How Does QE Affect Mortgage Interest Rates? Since mortgage interest rates track the long term T-Bill rates, as QE keeps these rates low, it also keeps mortgage interest rates low. As we know, however, QE1 and QE2 did little to lure home buyers from the sidelines. The result was that the housing industry continued in the doldrums and foreclosures surged as borrowers became trapped by loans that exceeded the falling value of their homes. Big banks, the primary beneficiaries of QE, held on to their money rather than lending it out. This increased their capital risk reserves and improved their balance sheet picture. And no thanks to Dodd-Frank, many potential home purchasers found that tight lender underwriting had locked them out of the marketplace for an affordable loan.
How Does QE Affect The Stock Market? With interest rates at all-time lows, retiree savings languished. But investors quickly took their available funds, and in a search for better returns, moved trillions into the stock market. While one might like to think the market has been on fire because publicly traded companies are doing everything right, the main impetus for the market’s all-time highs is because QE is pushing investors there rather than the lower yielding bond market.
What Will Happen When QE3 Is Discontinued? We already have had a preview. Although Mr. Ben Bernanke has consistently warned against discontinuing QE prematurely, in a congressional committee meeting on May 23, 2013, when ask when the Fed might cut back on the bond purchases, he responded that it might be some time in “the next few [FOMC] meetings.” The result was immediate. Quoting InvestmentNews.com:
Mortgage rates for 30-year loans surged to the highest level in almost two years, increasing borrowing costs at a time when the housing market is strengthening. The average rate for a 30-year fixed mortgage rose to 4.46 percent from 3.93 percent, the biggest one-week increase since 1987, McLean, Virginia-based Freddie Mac said in a statement. The rate was the highest since July 2011 and above 4 percent for the first time since March 2012.
Investors in the stock market reacted similarly. The Dow sank, as well as markets around the world; then they climbed back, sank again, and it has been on a wild ride ever since.
The Take-Away For Realtors®. With housing slowly emerging from the doldrums, and the construction industry still tentative, the QE issue is one that we need to keep watching. It is unclear whether QE3 or other economic factors developing over the past five years are responsible for the slowly improving economy, but one thing is certain: We’re not out of the woods yet. Main Street and Wall Street jitters will continue, and interest rates will likely continue to rise.
In short, our historically low interest rates have been QE driven. They are not the normal product of a healthy economy. For those brokers with clients looking for homes, financing will become an increasingly important issue, due not only to rising rates, but also due to regulatory measures next January that are designed to force closer attention on loan underwriting and borrowers’ ability to repay. The message is clear: Better to find good housing this year, lock in the interest rate, and settle in for a bumpy ride in 2014.
 It was first [unsuccessfully] tried by Japan’s central bank in the 1990s, resulting in what has become known as the “lost decade.”
 According to the Bureau of Labor Statistics, it was 7.6% for May, 2013 which is moving in the right direction but at a snail’s pace.
 “Long term” meaning ten years or more.