Making Sense of the FOMC Minutes' Impact on Mortgage Rates

Back in May and June, the Fed was either clearly finding a sense of urgency about managing the pace of asset purchases or they clearly wanted us to believe the same.  This resulted in the rapid rise in rates that we're all too familiar with. 

The tone of urgency changed fairly quickly as the Fed attempted to rein in what they characterized in policy statements as "tight financial conditions," which may as well read: "rates too high!"  The conclusion was that the Fed was ready to start backing down accommodation, but not too quickly.

As a part of the most recent effort to reassure markets about the "not too quickly" part, they set themselves up for the September's jobs report in that a weak number would fuel speculation of an increasingly delayed tapering process.  That's precisely what happened and precisely why 10yr yields tested the important 2.47% technical boundary shortly thereafter.

Now with the benefit of an additional jobs report (much stronger) and more importantly with today's FOMC Minutes, the reality is starting to sink in for market participants, and it's very much in line with our previous suggestion that the Fed is attempting to engineer a controlled sell-off in bond markets. 

That's not quite as scandalous as it sounds because when you get right down to it, it's sort of the Fed's job to always be engineering controlled sell-offs or rallies.  In this case, however, the stakes are higher and the broad-scale movement has been bigger.  Perhaps most frustrating is the fact that the communications required to direct this beast in the Fed's preferred direction have been more disjointed, contradictory, confusing, and tenuous than we might hope.  That's as much a factor of the unprecedented situation as anything, but it doesn't make it any less frustrating.

For fans of low, stable interest rates, there's precious little solace here, but at least we can better understand what the Fed is up to after a day like today where the FOMC Minutes release let us know what's really going on.  So here's what's really going on.

1. The Fed is still very interested in backing out accommodation.

Sure, they've had to say that accommodation is data dependent, and they indeed may be more than willing to leave it on the table as data allows, but all other things being equal, they're looking for ways to get out.  And if they can't justify getting out right this very minute, they're very interested in making contingency plans for the upcoming weeks and months.  They're also warming you up to feel more OK with tapering even with stagnant data in saying things like the following:

"In their discussion of the economic situation and the outlook, meeting participants generally indicated that the broad contours of their medium-term economic projections had not changed materially since the September meeting. Although the incoming data suggested that growth in the second half of 2013 might prove somewhat weaker than many of them had previously anticipated, participants broadly continued to project the pace of economic activity to pick up. "

2. They have been and will continue to be leaning heavily on a sentiment campaign to cushion the blow

This one is actually shockingly overt in today's minutes.  We don't have to guess about this one in the slightest.  They said it quite clearly:

"A couple of members also commented that it would be important to continue laying the groundwork for such a reduction in pace through public statements and speeches, while emphasizing that the overall stance of monetary policy would remain highly accommodative as needed to meet the Committee's objectives."

The sentiment campaign also involves telling markets how they should feel about recent policy statements.  This is a misdirection play where the Fed says that markets should be most focused on the forward rate guidance and keep it completely separate from asset purchases. 

"A number of participants noted that recent movements in interest rates and other indicators suggested that financial markets viewed the Committee's tools--asset purchases and forward guidance regarding the federal funds rate--as closely linked."

The fact is that market participants aren't nearly that confused by recent policy statements.  Sure, there may be a great deal of uncertainty about the employment metrics acting as thresholds for various policy actions, but there was little concern that the Fed would be raising rates any time soon.  The proof for this lies in the fact that they've recently been crystal clear in communicating "low rates into 2015 and beyond," yet 10yr yields still trade more than 1% higher than when the taper talk began in May.  The low rate guidance may be extremely important, but if it was the key issue at the moment, longer term rates would have responded much more readily.  It has been and continues to be mostly about the overall task of "backing out asset purchases" that are having the most immediate effect on rates.

3. The Fed isn't as concerned about economic headwinds as they've led you to believe

Case in point, here are a few selections from the minutes that highlight their take on the recent economic developments.  Keep in mind that the assessment of the labor market is being made BEFORE the Fed knew about the most recent, very strong jobs report!

"Although a number of participants indicated that the September employment report was somewhat disappointing, they judged that the labor market continued to improve, albeit slowly."

"They generally expected that the data would prove consistent with the Committee's outlook for ongoing improvement in labor market conditions and would thus warrant trimming the pace of purchases in coming months."

It's safe to say that these snippets are not in line with market consensus.  Before the last jobs report, the consensus on tapering was for March 2014! 

4. The Fed's consensus is most certainly NOT for March tapering

Either this, or again, that's what they want you to believe.  Either way, here's what they said:

"Many members stressed the data-dependent nature of the current asset purchase program, and some pointed out that, if economic conditions warranted, the Committee could decide to slow the pace of purchases at one of its next few meetings."

It's so critical to remember that the preceding statement was recorded BEFORE the last jobs report.  Data has been steady to strong since the last Fed meeting.  Even in these Fed minutes, see #3 above for an indication of how the Fed is assessing the data at their disposal.

5. If the Fed can't justify their agenda with the contingencies they've already laid out, they'll find another way

In other words, if "the game" isn't going how the Fed wants it to go, they will change the rules.  Here is the clue:

 "some participants noted that, if the Committee were going to contemplate cutting purchases in the future based on criteria other than improvement in the labor market outlook, such as concerns about the efficacy or costs of further asset purchases, it would need to communicate effectively about those other criteria. "

That might as well read: "if the labor market stuff isn't reason enough to taper, we just need to make sure we give them another reason." 

6. If the Fed can't convince you to look at the low interest rate guidance with their current rhetorical strategies, they'll try to find another way.

"Participants also discussed a range of possible actions that could be considered if the Committee wished to signal its intention to keep short-term rates low or reinforce the forward guidance on the federal funds rate. "

7. With respect to all of the above, the Fed isn't sure how to communicate this with you, and they're increasingly divided when it comes to making that determination.

"Members also discussed whether to add to the forward guidance in the policy statement an indication that the headwinds restraining the economic recovery were likely to abate only gradually, with the federal funds rate target anticipated to remain below its longer-run normal value for a considerable time. While there was some support for adding this language at some stage, a range of concerns were expressed about including it at this meeting. In particular, given its complexity, many members felt that it would be difficult to communicate this point succinctly in the statement. In addition, there was not complete consensus within the Committee that headwinds were the only explanation for the low expected future path of policy rates."

"Participants generally expressed reservations about the possibility of introducing a simple mechanical rule that would adjust the pace of asset purchases automatically based on a single variable such as the unemployment rate or payroll employment. While some were open to considering such a rule, others viewed that approach as unlikely to reliably produce appropriate policy outcomes. As an alternative, some participants mentioned that it might be preferable to adopt an even simpler plan and announce a total size of remaining purchases or a timetable for winding down the program. A calendar-based step-down would run counter to the data-dependent, state-contingent nature of the current asset purchase program, but it would be easier to communicate and might help the public separate the Committee's purchase program from its policy for the federal funds rate and the overall stance of policy. "

Even when/if they can figure out generally what to do, they can't quite agree on how to do it

"A number of participants believed that making roughly equal adjustments to purchases of Treasury securities and MBS would be appropriate and relatively straightforward to communicate to the public. However, some others indicated that they could back trimming the pace of Treasury purchases more rapidly than those of MBS, perhaps to signal an intention to support mortgage markets, and one participant thought that trimming MBS first would reduce the potential for distortions in credit allocation. "

That's scarcely the least of the "yeah buts" which which today's Minutes are riddled.  The conclusion is as follows:

The Fed is more interested in reducing asset purchases than they've let on, but almost as interested as it seemed like they were in May.  Either that, or that's what they want you to think.  They either don't agree on the reasons or simply have yet to be clear on why they're so intent on getting the hell out of the bond market, but clearly it keeps them up at night.  Even if they can soon agree that it's time to start getting out, there seems to be increasing disagreement about how to do it, and even more disagreement about how to communicate that to the masses.  Finally, if they can't communicate it with their current arsenal, they'll find another way to justify it and attempt to guide market reaction to the decision with sentiment campaign of misdirection. 

Bottom line: the Fed doesn't want to be buying bonds. They're not sure exactly when or exactly how, but it's a nagging urge.  They're not sure how to break it to you officially, but unofficially, they just did.