Why Mortgage Rates Remain So Low

I wanted to share this report with you as I try to stay on top of a number of various sources to write my reports each day.  This came from the TBWS group this morning and I wanted to share it with you.

Why do mortgage rates remain so low?  Yesterday, all thirty-four of the US largest banks "passed" the recent round of bank stress tests by the Fed, exceeding the minimum projected capital and leverage ratios under severely adverse scenarios, based on their projected ability to withstand economic shocks.

While this might be a real "yawner" to the marketplace, it brings up an important concept that no one is talking about. And that is the Stealth QE.

While the Federal Reserve Bank of New York has been purchasing and holding approximately 23% of MBS issues, there is a much larger form of QE in place. And BOTH are going to change in 2018.

What is the Stealth QE? As part of the Dodd-Frank Act, these bank stress tests were created along with guidelines and even mandates on not only capital ratios but what kind of capital. Of course, the banks can just keep cash on hand to meet their capital requirements, but then they basically will make no money on their reserves. Banks, of course, need to make money on their reserves. So, they're allowed to invest that money but only in very specific and safe things. This accomplishes two things, the capital is safe (thus being an actual reserve), and the banks get to make a small rate of interest revenue. (The third thing is that it created a Stealth QE which has kept the nation's borrowing costs to finance our record deficit very low as well as pushing mortgage rates lower).

This means the Fed and all the banks have been purchasing mortgage-backed securities in massive quantities REGARDLESS of market forces, economic growth, inflation, etc. This has kept MBS trading at least 300 BPS over and above where they would be trading right now if there was not all of this artificial demand (much lower rates). For example, if a solid PMI report hits and MBS move 12 BPS lower when historically, they would move 50 to 75 BPS lower. But they can't right now because regardless, the Fed and the banks are going to buy MBS.

First, the Federal Reserve has already published their plans to slowly and gradually reduce their purchases of MBS. This will begin in the 4th QTR and accelerate in 2018. Next, while Dodd-Frank may not be entirely repealed, much of the Act is subject to interpretation and leaves a great deal of it to regulators to design the rules. President Trump has already signed executive orders directing the Secretary of the Treasury to interpret Act a certain way and to rewrite the rules that are open to this interpretation. Also, the Fed is publishing several white papers on lowering the strict capital reserve requirements on banks. What will the result be? It will mean that banks will sell their low-return MBS and Treasuries and put that money to work loaning it out. This is actually very good for economic growth which is what the current administration is trying to do with all of this.

But the result will be that the artificial demand that controls well over 50% of all MBS purchases right now will begin to "normalize." And just like now, where MBS are purchased regardless of economic conditions......in 2018 and 2019...MBS will be SOLD regardless of economic conditions.

No, the "sky is not falling." But slowly and gradually over the next couple of years, this enormous demand will dissipate. This has NEVER existed in the MBS marketplace before. Yes, we have been through the "tapering" and ending of their official, QE1, QE2, etc. But during those times, the Stealth QE was still in place. Now, we are talking about removing the Stealth QE over time. So, historical trends of MBS won't mean anything during these periods and real economic data will once again have a real impact on mortgage rates. But again...this is not NOW it is later in 2018 and 2019.

Enjoy the great rates that we have now and will continue to enjoy for some time. Even if MBS sell off a 100 BPS tomorrow (which they will not) it STILL would mean that MBS are trading by 300BPS higher than they would be if 50% of all demand did not come from the Fed/Banks.