Salient to Investors:

Michael Cudzil at Pimco said:

  • The Fed will taper because it looks at progress over a long-term period of time, rather than any one given month, and because there are doubts among some policy makers about how effective QE has been in boosting the economy amid concern it may spur excessive risk-taking.
  • The Fed has prepared the markets and will take this as an opportunity to make the move and see how they react.
  • The Fed may slow its home-loan debt buying less than its Treasury acquisitions because of signs of housing weakening and because recent academic papers argue that Treasury buying is less impactful.
  • The Fed is most likely to equally reduce mortgages and Treasuries purchases, while some Fed policy makers prefer owning only Treasuries. Falling mortgage issuance may make it harder for the Fed to find enough bonds to buy at the current pace, and slowing debt repayments mean the asset may remain outstanding for longer on its balance sheets than officials want.

Average rates for 30-yr mortgages reached a 2-year high of 4.58 percent last week. The 35 percent increase over 17 weeks in the 30-year fixed home loans is the fastest in a comparable period since at least 1972.

Joseph Galligan at DoubleLine Capital said rising rates will impact the housing recovery and Fed officials know this, and the Fed is most likely to equally reduce mortgages and Treasuries purchases.

Nicholas Strand et al at Barclays expect tapering in September, and said the Fed’s lower buying will be especially important for agency mortgage bonds because there is no obvious source of extra demand, as banks face new regulations, REITs are unlikely to raise new capital after stock slumps, and bond mutual funds face redemptions.

New US homes sales in July fell the most in more than 3 years and to a level lower than any forecast of 74 economists.

Laurie Goodman et al at Amherst Securities said higher rates have reduced refinancings in 15 of the past 16 weeks and to a 2-year low, paring expectations for mortgage-bond issuance, and that without any stimulus pullback, the Fed’s buying will account for 75 percent of the type of new bonds it is targeting by Q4. The analysts said that simple math means the Fed must taper dramatically, as it needs to cut purchases by 40 percent if it is to maintain its 56 percent share of issuance in Half1.

Ankur Mehta et al at Citigroup said investors should not jump to the conclusion that the Fed will need to reduce its buying to avoid disrupting the market’s liquidity because originators typically use forward contracts to sell future issuance a month or two before completing loans, meaning the Fed’s growing share of buying is already occurring, while at the same time, data show fewer failed trades and other measures are not signaling bonds are hard to find. The Citigroup analysts believe the Fed could modestly bias their tapering towards Treasuries in the September meeting, but that preference is unlikely to be very decisive.

Matt Jozoff et al at JPMorgan expect tapering to start in September, along with 65 percent of economists.

Mahesh Swaminathan et al at Credit Suisse assign a high probability to a September tapering despite the recent string of weak economic data, but said that even if tapering is delayed, the continued overhang of tapering soon should limit relative gains in home-loan securities, and recommended investors add to bets that certain bonds will underperform rate swaps.

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