The Federal Reserve will move ahead with its much-speculated second round of quantitative easing to promote a stronger economic recovery pace and to ensure that inflation, over time, remain at levels consistent with its mandate.
As expected, the Fed will undergo a $600 billion purchase program of longer-term Treasury securities by the end of the 2Q11, which is a pace of about $75 billion per month.
It also plans to reinvest principal payments from agency debt and agency MBS into longer-term Treasury securities. Based on current estimates, the Fed expects to reinvest $250 billion to $300 billion over the same period, though the realized amount of reinvestment will depend on the evolution of actual principal payments.
According to a statement released by the Fed, the Federal Open Market Committee (FOMC) seeks to foster maximum employment and price stability. The FOMC cited the elevated unemployment levels as well as the relatively low measures of underlying inflation versus the levels that the FOMC considers consistent, over the longer run, with its dual mandate.
Although the FOMC has been expecting a gradual return to higher levels of resource utilization in terms of price stability, progress toward its objectives is seen as disappointingly slow.
It will monitor the economic outlook and financial developments as well asl employ its policy tools as needed.
The Fed's announcement is fairly close to market consensus, according to Bank of America Merrill Lynch analysts.
The bank's analysts' base case estimate was that the Fed will purchase $500 billion in the next six months in Treasurys. The Fed announced that it will purchase $600 billion Treasurys outright by June 2011. This is in addition to the $250 to $300 billion reinvestment of MBS paydowns in U.S. Treasurys.
Contrary to the general expectations of some MBS players BofA Merrill analysts said that the Fed did not commit to purchasing any MBS as part of this purchase program. But, the Fed left the door open for further purchases. The Fed did mention that it will review security purchases regularly. If MBS spreads were to widen materially, analysts think that the Fed will review their allocations in the purchase program.
From a overall rate perspective, analysts see the Fed's announcement as positive for agency MBS. Analysts predict that 10-year rates will remain range bound while volatility will head lower. They also expect five-year rates to stay low. This makes MBS attractive relative to the five-year sector, and five year to 10-year to remain steep, which reduces chances of a further rally in mortgage rates.
Analysts added that the market comfort around prepayments at current rate levels is also a positive factor. But, around $30 billion per month in Fed paydowns that will not be reinvested in MBS is still the key challenge for the MBS market.
That said, added liquidity through the Fed purchases should eventually drive added demand for mortgages either from banks or money managers. The long-term risk to the basis, analysts said, is a gradual rise in lending capacity as mortgage rates are likely to remain low for an extended time period.