Mortgage - Treasury Spread closes sharply in January - is Fed buying bringing stability?

In a month which saw the lowest 30-year fixed rates on record, it isn't surprising that the massive groundswell of refinancing we experienced happened. Its consequences could also be seen as quite predictable: lenders, fresh from laying off thousands of employees in 2008, saw their operations grind to a halt as they received an onslaught of mortgage applications. The reprecussions to market interest rates were rather more cryptic, though.  By the end of January, the Mortgage-Treasury Spread had closed to its tightest range since September, 2008, closing the month at 2.28%. 

The 10-week moving average stayed relatively level at 2.78%, bouyed by much broader weekly spreads in December and early January.

The Mortgage-Treasury Spread is a measurment reflective of the relative perceived risk between mortgage securities and U.S. Treasury securities.  A higher spread indicates investors fear mortgages are more likely to default, while a lower spread is suggestive of mortgage-market stability.  Until July, 2007, the spread had experienced an unprecedented period of stability in the 1.4% to 1.6% range, but concerns stemming from the current crisis in confidence for mortgage assets has pushed that spread as high as 3.12% in December of 2008.

Moving into February, there are a number of factors that should put pressure on the Mortgage - Treasury spread, but only two of real significance.  The US Treasury will be embarking on a massive borrowing campaign in order to fund the continuing bailout and economic stimulus efforts, and is expecting to sell over $400 billion in new securities.  Ordinarily, such an increase in supply (when the Treasury borrows, it sells Treasury bonds, bills and notes, effectively increasing the quantity of such instruments in the marketplace), would have a significant effect on treasury iterest rates, as investors begin to require a higher return in order to justify their investment. 

Offsetting that is the promise from the Federal Reserve to take an active role in controlling treasury rates by buying long-dated securities.  The Fed alluded to this possibility in its January 28th announcement, saying that it would be closely watching markets for these securities, and would intervene by buying securities if rates became too high. 

How does the Fed intend to do this? 

Already, Fed Chair Benjamin Bernanke has injected nearly $2 Trillion into asset markets in recent months, to the point where the Fed's ability to invest further is limited by lack of available funds. Of course, the Federal Reserve controls the world largest source of funding, its own printing presses.  Essentially, any further market action by the Fed is likely to be accompanied by a significant increase in the quantity of US currency in circulation as the angecy uses inflation to control interest rates.  Will it work?

Only time will tell.

Dan Hartman is a Senior Mortgage Advisor with Province Mortgage Associates, and has over 9 years experience in mortgage lending.  A 2005 MBA graduate of Clark University's Graduate School of Managment, Dan also serves as an Adjunct Professor of Finance at the University of New Haven and Roger Williams University.