Fed holds off on changes

The Federal Open Market Committee left interest rates unchanged, as expected, at yesterday’s meeting. There were no significant wording changes to its post-meeting statement, and it even retained the pledge to keep interest rates “exceptionally low” for an “extended period.”

Punting until the next FOMC meeting, April 27-28, buys more time to evaluate the economy — another employment report, another Beige Book, and time for the choppy, weather-impacted February economic readings to give way to hopefully more telling March data.

But the Federal Reserve is content to stop the mortgage purchase program this month and let the market take over. At the very least, we can expect an uptick in mortgage rate volatility — which has been noticeably absent thus far in 2010. With the Fed no longer the dominant purchaser of Fannie and Freddie mortgage-backed securities, investors must fill the void.

The question is whether those investors will pay the prices the Fed has been paying. The difference between the average conforming 30-year fixed mortgage rate according to Bankrate.com’s weekly national survey and yields on 10-year Treasury notes — known as a mortgage risk premium or credit spread — is 145 basis points. A basis point is one one-hundredth of 1 percentage point. We haven’t seen spreads at these levels consistently since 1998. The average spread from 1985 until the onset of the credit crunch in 2007 was 164 basis points. Lower spreads mean that buyers — i.e., the Fed — are paying higher prices as bond prices and yields move in opposite directions.

Given the ongoing mortgage defaults, uncertainty about the housing market, and prospects for higher rates in the future, an argument can be made that the “new normal” is something north of the “old normal” of 164 basis points. If investors, absent the Fed’s buying power, commanded more compensation for risk, pushing the spread to 170 basis points, we’re looking at a quarter-point increase in mortgage rates. My personal forecast is for a half-point increase in mortgage spreads. The ultimate impact on mortgage rates could be more or less, depending on the movement of benchmark Treasury yields. This may not occur in one fell swoop, but play out over a period of weeks. And if so, buckle your seat belts because the mortgage rate ride is about to get bumpy.