As the economy continues to expand and inflation expectations continue to rise (at least as priced by the fixed-income markets1), the likelihood of the U.S. Federal Reserve (Fed) ending its reinvestment of agency mortgage-backed securities (MBS) has risen. Today, there is media and market chatter that the end of reinvestments could occur after just a few more interest rate hikes. As this risk rises, it is likely, in our view, that the spreads on agency MBS could widen and cause them to underperform other investment-grade fixed-income assets.
Given this risk, our Domestic Debt Team has an underweight position in these securities. We would consider adding some MBS should the market price for an eventual taper or suspension of principal reinvestments. However, given that MBS spreads are near their recent tight levels, it does not appear to us that the market has priced Fed tapering yet (Exhibit 1).
The Fed’s Balance Sheet Evolution
It’s important for investors to take a step back and understand some of the details of the Fed’s balance sheet evolution. Prior to the 2008 financial crisis, the Fed held securities on its balance sheet in the normal conduct of monetary policy. When the Fed began its extraordinary monetary-policy accommodation measures (i.e., quantitative easing) as part of its crisis response in 2008, it started purchasing agency MBS first, followed by federal agency debt and Treasuries (Exhibit 2).
After accumulating more than $2.6 trillion in additional assets, the Fed announced its plan to reinvest maturing MBS. That meant the principal value of maturing MBS held by the Fed would be reinvested in similar securities. Interest earned on these securities is booked as profit and is ultimately paid to the U.S. Treasury Department. This policy of reinvestment has kept the Fed’s holdings of MBS virtually constant. From December 2013 to October 2014, the Fed tapered and then ceased its asset purchases. Over the last few years the Fed’s balance sheet has held at a relatively constant size of $4.5 trillion.
Since reinvestments began, mortgage spreads have been supported by the Fed’s reinvestment program. Market technicals—such as the Fed’s purchase of a significant portion of gross mortgage issuance every month—has meant there have been fewer available agency MBS for investors who typically purchase them. As Exhibit 1 shows, MBS OAS spreads have narrowed with the Fed’s market intervention.
The Fed Is Likely to Reduce Its Exposure to Agency MBS, Not Treasuries
Many members of the Fed have stated that they are interested in getting back to a Treasury-only portfolio. The policy-setting arm of the Fed (i.e., the Federal Open Market Committee, or FOMC) has also expressed in its statement of exit principals several years ago that it would continue to hold enough Treasuries to conduct monetary policy. This policy has also been reiterated by Fed chairwoman Janet Yellen and others since that time.
Without getting into too much detail, here’s some context: The Fed generally conducts monetary policy by either lending or borrowing Treasury securities in the market (for more, see our previous blog, The Fed’s Modern Tools for Setting Interest Rates). Prior to the 2008 crisis, the Fed owned between 15% and 17% of the U.S. Treasury market. As of year-end 2016 it owned 17%. By year-end 2017 (using the Congressional Budget Office’s deficit projections for 2017) the Fed should own just about 16% of the Treasury market.
In our view, it is not obvious the Fed will need to reduce the amount of Treasury holdings on its balance sheet, particularly given the Treasury market’s size and the Fed’s need to conduct future monetary operations using these assets. However, it is possible at some point that the Fed will change the composition of its holdings, such as through buying short-term Treasury bills instead of longer-maturity notes and bonds with proceeds from maturing securities. The Fed can also perform a “reverse” twist, whereby it would sell long-term bonds to buy short-term bonds. However, we would expect any balance-sheet transformation to occur more passively to reduce market turbulence.
A Look Ahead: What’s Next for Agency MBS Reinvestment?
The Fed decided to leave the federal funds rate unchanged at its FOMC meeting on February 1. Yet it continued to note moderate economic growth and expressed its expectation of an uptick in inflation. The longer the federal funds rate remains unchanged, the longer we believe it will take for the Fed to end its policy of agency MBS reinvestment. But with the Fed continuing to hint that three hikes later this year are possible, and with economic momentum continuing apace, talk of tapering MBS reinvestment may come sooner than the market is currently pricing.
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1. The break-even inflation rate of the 10-year U.S. Treasury Inflation Protected Security notes and typical 10-year U.S. Treasury notes has risen by 0.6% since early September.
2. Source: Barclays. Option-adjusted spreads (OAS) is a methodology using option-pricing techniques to value the implied options risk component of a bond’s total spread due to different pre-pay characteristics in mortgage-backed securities.
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Mutual funds and exchange traded funds are subject to market risk and volatility. Shares may gain or lose value. Mortgage-backed securities are subject to prepayment risk. Fixed income investing entails credit and interest rate risks. Interest rate risk is the risk that rising interest rates or an expectation of rising interest rates in the near future, will cause the values of a fund’s investments to decline. Risks associated with rising interest rates are heightened given that rates in the U.S. are at or near historic lows.
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