Market Review
August 2010

As the pace of growth in the US economy continues to slow, the rallies in treasury and mortgage prices keep pushing forward.  The yield on 10-yr treasury securities has dropped below 2.75% and 3.5% coupon Fannie Mae 30-yr securities are now trading above par.  Those looking for clearer signs of life in the economy had thought they'd seen a glimmer in non-farm payroll gains that had moved positive earlier this year.  But, as the temporary census workers were let go, overall job growth slipped back into negative territory and private sector job growth has been too modest to inspire long term confidence.

The most recent FOMC meeting held on August 10 added more fuel to the bond fire.  While it is widely accepted that the Fed is unlikely to raise their Fed Funds target for at least several more months, debate has been shifting to the likely direction of the Fed's balance sheet.  With the Fed's securities portfolio sitting and around $2 trillion and given that the portfolio will naturally shrink as principle payments are received and debt matures, the question arises as to whether and how the Fed will reinvest those funds.

To answer that question, at least in the intermediate term, the Fed announced that they will offset portfolio shrinkage with the purchase of additional treasury securities, primarily in the 2- to 10-yr sector of the curve.  While this means that no further mortgage-backed security purchases are contemplated for the time being, mortgages were still able to take advantage -- along with treasuries, of course - of the news that the Fed would look to maintain the approximate size of their portfolio through treasury purchases.

Although it's reasonable to expect that the Fed's new treasury purchase program will widen mortgage spreads vs. treasuries, anything that keeps treasury rates low will likely help keep mortgage rates low as well.  Given where treasury yields sit, investors will continue to look for products like mortgages that provide higher yields.  In the current environment, any significant widening of mortgage spreads may be met with enough demand to curtail further movement. – Lindsay Hill