The Federal Reserve undertook two types of stimulus since August 31, 2007. The first was a lowering of The Fed Funds target rate of interest.
Well, lowering the Fed Funds target rate to near zero by December 2008 didn’t do the trick of stimulating the economy, so The Fed launched their second wave of stimulus known as Quantitative Easing (QE). Essentially, The Fed decided to purchase Treasury bonds (and Agency Mortgage-backed securitie (MBS) to help drive down interest rates.
Below are three different yield curves. One of June 29, 2007 BEFORE The Fed started lowering The Fed Funds Target rate. The second one is for late November 2008 when The Fed announced QE1. The third yield curve is today’s yield curve.
Notice how flat the yield curve was on June 29, 2007. The Fed helped steepen the yield curve by lowering The Fed Funds Target rate. You can see the steepness of the curve as of November 25,2008 with the near zero rates at the short end. Today’s yield curve is about 100 basis points lower at the 10 year.
The spread between the 30 year fixed-rate mortgage and the 10 year Treasury yield is about 164 basis points (or 1.64%).
An increase in The Fed Funds Target rate will raise the short end of the yield curve. The mid and long sections of the yield curve may not be impacted, unless The Fed decides to terminate QE and start selling their bond and MBS holdings. But according to the expectations hypothesis of the term structure, a rise in the Fed Funds target rate should cause the rest of the yield curve to rise, including the 10 year yield.
Of course, the 10 year Treasury 10 is also impacted by economic expectations, both domestic and foreign. Worsening conditions in China and Europe can push the 10 year Treasury yield down … again and mortgage rates as well.
Pension funds and investors holding Treasuries and agency MBS are not looking forward to interest rate increases. The red boxes show the decline in MBS prices with local increases in the 10 year Treasury yield.
While The Fed may hold steady on a September rate increase, there is a good chance that there will be a December rate increase.
Perhaps Janet Yellen will announce a rate increase with the help of a dummy to deflect any attacks if the yield curve rises and markets tank.