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Even the most ardent supporters of the Federal Reserve's policies might acknowledge that their numerous benefits are accompanied by some negative implications. And for investors, one of these implications may be uncertainty about the appropriate level of interest rates based on economic and market conditions, regardless of the central bank's broad influence.
The interest-rate uncertainty has mounted along with more frequent comments from Fed members questioning whether the risks involved with the central bank's asset purchases offset the economic benefits. Yet, the interest-rate environment could remain relatively stable over the foreseeable future as a result of the Fed's ongoing emphasis on housing and the composition of its massive balance sheet.
The Fed's focus on the housing market has been logical, considering its role in the financial crisis and the recession. And housing now appears to have recovered to the point where its support for other segments of the economy could "cause overall growth to be stronger than expected this year," according to the assessment of several Fed members during its most recent meeting in late January. The Fed's recent comments could even appear self-congratulatory based on its multipronged efforts to lower interest rates that directly affect the cost of home loans.
Indeed, if lower mortgage rates have been crucial to housing's recovery and to the possibility of stronger than expected economic growth, then the Fed has provided considerable momentum to that trend through its program to purchase $40 billion in agency mortgage-backed securities1 (MBS) per month. This initiative essentially reduced the spread between agency MBS yields and Treasury yields by about half. (See Chart 1.)
Yield spread between agency MBS and Treasury yields, 02/01/2012-02/13/2013
See footnotes 6 and 7 for references to yield spread and basis points, respectively.
Past performance is no guarantee of future results. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
The decline in mortgage rates also produced another wave of refinancing activity, such that refinancings comprised more than 80% of all new home loans following the announcement of the Fed's purchases of agency MBS. As the housing market continues to recover, the refinancing percentage has eased slightly, to about 75% of all new loans.2 And considering an economy that is still growing sluggishly, and with a stubbornly high unemployment rate, the Fed may be reluctant to prematurely constrain the ability of homeowners to refinance and otherwise improve their monthly cash flows. After all, an increase in the 10-year Treasury yield to 2.25% to 2.50% could easily push mortgage rates above 4%, potentially squelching the economic benefits of home purchases and refinancings.
Indeed, supporting homeowners' monthly cash flows could become a heightened priority going forward, considering the recent 2% increase in the payroll tax, gasoline prices that are near record levels, and the looming sequestration of $85 billion in federal spending cuts. This combination points to the continuation of an economic environment wherein the 10-year Treasury yield has remained near, or below, 2%.
Another consideration regarding the potential for interest-rate volatility lies in the composition of the Fed's balance sheet. Although Fed members suggested at their late-January meeting that the central bank should prepare to vary the pace of its asset purchases, there was an accompanying suggestion that the Fed could hold its assets for longer than initially anticipated. This extension would be seen as a supplement to, or replacement of, asset purchases. By holding a stockpile of more than $3 trillion in Treasury and agency MBS for longer than expected, the Fed may continue to influence the market dynamics that have, historically, led to bouts of interest-rate volatility.
For example, falling interest rates tend to generate refinancing activity, which essentially calls mortgages—most of which have long maturities3—away from fixed-income investors and can shorten the durations4 of their portfolios. And the opposite can happen in an environment of rising interest rates, when fewer homeowners refinance, thus leaving more mortgages in the hands of investors and potentially lengthening their durations. That's generally not a desirable outcome when interest rates are rising, so investors might sell long-duration assets, such as Treasuries and agency MBS, to compensate. This dynamic can lead to a cyclical pattern of interest-rate turbulence.
In the current environment, however, the Fed has purchased more than $1 trillion in agency MBS with maturities of 10 years or longer as of late February 2013. This amount represents about 30% of the outstanding MBS market.5 In addition to its holdings of more than $400 billion in Treasury notes with maturities of 10 years or longer, the Fed has removed a significant amount of long-duration assets from the market. And with fewer long-duration assets to hold, the Fed may have significantly muted the cyclical effect that can cause volatility when interest rates start to drift higher.
Although Fed members recently questioned the Fed's quantitative easing programs, there appears to be more agreement among members that the economy, and housing in particular, need further support through monetary policy. A significant part of this support has come from the Fed's balance sheet, and even if it decides to adjust its asset purchases going forward, the composition of its massive asset holdings could dampen interest-rate volatility going forward.
A Note about Risk: Investing involves risk, including the possible loss of principal. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. No investing strategy can overcome all market volatility or guarantee future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.