Economic Commentary for June 27th, 2013: Fed Prepared to Taper

New Home Sales

The June 19 Fed announcement laid out the clearest plans yet for scaling back the Fed’s bond buying program. If the economy matches the Fed’s growth forecasts, then the Fed expects to taper later this year. Mortgage rates shot upward after the announcement and remain higher today.

The magnitude of the rapid rise in mortgage rates has been shocking, but the reason is clear. To help boost the economy over the last few years, the Fed initiated an unprecedented program to purchase enormous quantities of Treasuries and mortgage-backed securities (MBS). The added demand from the Fed distorted MBS markets and pushed mortgage rates (which are mostly determined by MBS prices) down to historically low levels.

Now, the economy has improved. With steady economic growth, the Fed has indicated that it’s almost time to scale back (taper) its bond purchases. Investors are now trying to determine the “proper” level of mortgage rates in a growing economy in the absence of unnatural demand from the Fed. While investors go through this process, mortgage rates are likely to remain volatile. This was seen in the reaction by investors to the unexpected downward revision to the first quarter GDP data. Mortgage rates improved immediately following the announcement.

Looking ahead, the next major economic event on the horizon will be the Employment report on July 5. The strength of the labor market is a primary factor in determining when the Fed will taper. Comments from Fed officials will have market moving potential as well. Investors also will be watching the impact of the rapid rise in European bond yields on the stability of EU countries with very high debt levels. Another area to watch is China, which is attempting to rein in its bank lending. Monetary policy changes in China could cause a reaction in US financial markets.