A historical look at changes in Fed and Treasury holdings
While the Fed’s action may have one set of expectations in the short term, multiple macro factors could affect MBS spreads over the medium term. Nonetheless, an analysis of the historical record of QE supports the notion that, all else being equal, the change in supply and demand resulting from a gradual and predictable tapering of reinvestments would be only a marginal headwind on MBS spreads. Let’s look at that past record.
In a key move to QE during the global financial crisis, in November 2008, the Fed announced QE1 in both Treasurys and agency MBS. The program was in place until March 2010 when the Fed’s portfolio reached $1.2 trillion in MBS and $800 billion in Treasurys. Similar to the current environment, the Fed halted purchases as the economy improved but resumed them in August 2010 when the economy faltered. The Fed initiated a reinvestment program in August–September 2010 to keep the balance sheet from running off.
Between March 2010 and March 2011, the Fed gradually ended MBS QE, with that portion of the Fed balance sheet shrinking by $200 billion. However, in November 2010, the Fed announced QE2, and focused on buying $600 billion of Treasurys through the second quarter of 2011.
At first glance, QE2 coupled with shrinking MBS holdings should have been a massive MBS spread widener over that time frame. However, spreads were only 10 basis points wider, initially tightening 15 basis points, then widening 44 basis points from those tight spreads into November 2010, followed by a move to tighten further.
It is important to note that initial conditions in both spreads and volatility were higher than current levels. But as the Fed’s ebb and flow of agency MBS and Treasury securities changed, the demand side (excluding the Fed) changed as well. Between the second quarter of 2010 and the first quarter of 2011, banks and money managers each added $130 billion in agency MBS.
When the market absorbed the exit from MBS
Looking back to the March 2011–March 2012 period, the market absorbed the Treasury’s exit from its agency MBS portfolio. Over this period, the US Treasury sold $142 billion of these securities ($10 billion to $12 billion a month), the only post-financial crisis instance of active official selling. This added net (excess) supply to the market. As the next chart illustrates, spreads widened 5–7 basis points per $10 billion of selling in the first five months and then reversed, ending the year only 10 basis points wider.
In September 2012, the Fed introduced a third round of quantitative easing, QE3, focused on MBS. Initially, purchases started at $40 bil- lion a month, and were upsized to $85 billion in December 2012. Between January and October 2014, the Fed tapered these QE purchases and replaced them with the reinvestment program that is in effect today. Over that time frame, the size of the Fed’s MBS purchases, as a percentage of gross MBS issuance, dropped from 90% to 35%. However, as purchases were reduced, spreads actually tightened 20 basis points, a trend that continued to the end of 2014.
Expectations of current tapering
Given this historical backdrop, we think MBS spreads are unlikely to widen over the near term, as a result of the Fed’s announcement alone. A sharp move of +/-25 basis points will change prepayment fundamentals and affect spreads, as extension and refinancing risks manifest themselves.
From a prepayment standpoint, a move below 3.5% on mortgage rates from the current 4% range is anticipated to significantly increase refinancing activity. Absent a recessionary outcome, such a lowering in rates does not look to be in the cards for a sustainable period of time. Should rates move sharply higher, it is anticipated that prepayment risk would decrease but mortgage durations would initially extend . The extension potential is limited in the historical context — particularly considering what the market experienced last fall after the 2016 US presidential election.
Over the medium term, we expect the balance sheet runoff to be marginally negative. However, we are less focused on its impact relative to net issuance, as the Fed is not actively selling holdings but gradually reinvesting less. Moreover, over longer horizons, the stock effect of the Fed’s holdings is more relevant. In spite of Fed members’ rhetoric of a preference for an all-Treasury balance sheet, the June 2017 Addendum to the Policy Normalization Principles and Plans did not include that objective.
In line with this, we would assume the Fed’s terminal balance sheet composition would include agency MBS, and we expect the Fed’s agency MBS holdings to decrease from the current 26% to approximately 20% of the mortgage market over the next five years. This factor, in our opinion, will remain a structural headwind to a significantly wider move in spreads.
On the demand side, while relative value consideration may imply multiple outcomes for money managers, the outlook for banks is likely to be shaped by lower excess reserves, capital and market liquidity regulatory constraints, and net interest margins. As excess reserves continue to shrink, banks will need high-quality liquid assets such as Treasurys and agency MBS to maintain liquidity coverage ratios. Higher agency MBS holdings relative to Treasurys also support net interest margins for banks.
Originally published October 2017
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt. The views expressed represent the Manager’s assessment of the market environment as of October 2017, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager’s views. INSIGHT-FTH 1710 (XXXXX-mm/yy) Contact us by region Americas, Market Street, Philadelphia 215 255 1200 email@example.com Asia, Harbor View, Hong Kong 852 3922 1256 firstname.lastname@example.org Australia, Martin Place, Sydney 1800 814523 email@example.com Europe/Middle East/Africa, Ropemaker Place, London 44 020 3037 2049 firstname.lastname@example.org This information is confidential and intended for the audiences as indicated below. It is not to be distributed to, or disclosed to retail investors. The views expressed represent the Manager’s as of the date indicated, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice. The information in this document is not, and should not be construed as, an advertisement, an invitation, an offer, a solicitation of an offer or a recommendation to participate in any investment strategy or take any other action, including to buy or sell any product or security or offer any banking or financial service or facility by any member of the Macquarie Group. The information presented is not intended and should not be construed to be a presentation of information for any U.S. mutual fund nor an offer for any product or service in any jurisdiction where it would be unlawful to do so. This document has been prepared without taking into account any person’s objectives, financial situation or needs. Recipients should not construe the contents of this document as financial, investment or other advice. It should not be relied on in making any investment decision. Future results are impossible to predict. This document contains opinions, conclusions, estimates and other forward-looking statements which are, by their very nature, subject to various risks and uncertainties. Actual events or results may differ materially, positively or negatively, from those reflected or contemplated in such forward-looking statements. Past performance information shown herein, is not indicative of future results. This presentation does not contain all the information necessary to fully evaluate any investment program, and reliance should not be placed on the contents of this document. Any decision with respect to any investment program referred to herein should be made based solely upon appropriate due diligence by the prospective investor. The investment capabilities described herein involve risks due, among other things, to the nature of the underlying investments. All examples herein are for illustrative purposes only and there can be no assurance that any particular investment objective will be realized or any investment strategy seeking to achieve such objective will be successful. No representation or warranty, express or implied, is made as to the accuracy or completeness of the information, opinions and conclusions contained in this presentation. In preparing this presentation, reliance has been placed, without independent verification, on the accuracy and completeness of all information available from external sources. To the maximum extent permitted by law, neither MIMBT nor any member of the Macquarie Group nor their directors, employees or agents accept any liability for any loss arising from the use of this presentation, its contents or otherwise arising in connection with it. Other than Macquarie Bank Limited (MBL), none of the entities noted in this presentation are authorised deposittaking institutions for the purposes of the Banking Act 1959 (Commonwealth of Australia). The obligations of these entities do not represent deposits or other liabilities of MBL. MBL does not guarantee or otherwise provide assurance in respect of the obligations of these entities,unless noted otherwise. For recipients in the United States: This information may only be used with institutional investors. Macquarie Asset Management (MAM) offers a diverse range of products including securities investment management, infrastructure and real asset management, and fund and equity-based structured products. Macquarie Investment Management (MIM) is the marketing name for the following registered investment advisers: Macquarie Investment Management Business Trust (MIMBT), Macquarie Funds Management Hong Kong Limited, Macquarie Investment Management Austria Kapitalanlage AG, Macquarie Investment Management Global Limited, Macquarie Bank International Limited, and Macquarie Capital Investment Management, Inc. Institutional investment management is provided by Macquarie Investment Management Advisers (MIMA), a series of MIMBT. MIMBT is a U.S. registered investment advisor, and may not be able to provide investment advisory services to certain clients in certain jurisdictions. Within the European Economic Area, this document is a financial promotion distributed by Macquarie Investment Management Europe Limited (MIMEL) to Professional Clients or Eligible Counterparties defined in the Markets in Financial Instruments Directive 2004/39/ EC. MIMEL is authorised and regulated by the Financial Conduct Authority. MIMEL is incorporated and registered in England and Wales (Company No. 09612439, Firm Reference No. 733534). The registered office of MIMEL is Ropemaker Place, 28 Ropemaker Street, London, EC2Y 9HD. The investment capabilities described herein are managed by Macquarie Investment Management Europe Limited (MIMEL), with day-to-day management responsibilities sub-delegated to relevant affiliated managers. In Switzerland this document is distributed by Macquarie Bank Limited Zurich Representative Office. In Switzerland this document is directed only at qualified investors (the “Qualified Investors”), as defined in the Swiss Collective Investment Schemes Act of 23 June 2006, as amended (“CISA”) and its implementing ordinance. Zurich Representative Office, Claridenstrasse 41, 8002 Zurich, Switzerland. For recipients in Australia: This document is provided by Macquarie Investment Management Global Limited (ABN 90 086 159 060 Australian Financial Services Licence 237843) solely for general informational purposes. This document does not constitute a recommendation to acquire, an invitation to apply for, an offer to apply for or buy, an offer to arrange the issue or sale of, or an offer for issue or sale of, any securities in Australia. This document has been prepared, and is only intended, for ‘wholesale clients’ as defined in section 761G of the Corporations Act and applicable regulations only and not to any other persons. This document does not constitute or involve a recommendation to acquire, an offer or invitation for issue or sale, an offer or invitation to arrange the issue or sale, or an issue or sale, of interests to a ‘retail client’ (as defined in section 761G of the Corporations Act and applicable regulations) in Australia. For recipients in PRC: Macquarie is not an authorized securities firm or bank in the People’s Republic of China and does not conduct securities or banking business in the People’s Republic of China. For recipients in Hong Kong: This document is provided by Macquarie Funds Management Hong Kong Limited (CE No. AGZ772) (MFMHK), a company licensed by the Securities and Futures Commission for the purpose of giving general information in relation to the strategy(ies) described herein. The information contained in this presentation is provided on a strictly confidential basis for your benefit only and must not be disclosed to any other party without the prior written consent of MFMHK. If you are not the intended recipient you are not authorised to use this information in any way. This presentation does not, and is not intended to, constitute an invitation or an offer of securities, units of collective investments schemes or commodities (or any interests in any index thereof) for purchase or subscription in Hong Kong. The information in this presentation is prepared and only intended for professional investors and not to any other person. This presentation has not been approved or reviewed by the Securities and Futures Commission. For recipients in Korea: This document is provided at the specific request of the recipient who is a person specified under Article 101(2) of the Presidential Decree of the Financial Investment Services and Capital Markets Act (Act) without any solicitation by Macquarie. Therefore, this document may not be distributed, either directly or indirectly, to others in Korea. The person receiving this document represents and warrants that if it receives this document, it is a professional investor as defined under the Act. No member of the Macquarie Group makes any representation with respect to the eligibility of any recipients of this presentation to acquire the products or services therein under the laws of Korea, including but without limitation the Foreign Exchange Transactions Act and Regulations thereunder. The products and services have not been registered under the Act, and none of the interests may be offered, sold or delivered, or offered or sold to any person for re-offering or resale, directly or indirectly, in Korea or to any resident of Korea except pursuant to applicable laws and regulations of Korea. For recipients in Malaysia, Taiwan, The Philippines: This document is provided at the specific request of the recipient For recipients in Singapore: The Strategies which are the subject of this document do not relate to a collective investment scheme which is authorised under section 286 of the Securities and Futures Act, Chapter 289 of Singapore (the “SFA”) or recognised under section 287 of the SFA. The Strategies are not authorised or recognised by the Monetary Authority of Singapore (the “MAS”) and shares are not allowed to be offered to the retail public. Each of this document and any other document or material issued in connection with the document is not a prospectus as defined in the SFA. Accordingly, statutory liability under the SFA in relation to the content of prospectuses would not apply. You should consider carefully whether the investment is suitable for you. This document has not been registered as a prospectus with the MAS. Accordingly, this document and any other document or material in connection with the offer or sale, or invitation for subscription or purchase, of shares may not be circulated or distributed, nor may shares be offered or sold, or be made the subject of an invitation for subscription or purchase, whether directly or indirectly, to persons in Singapore other than (i) to an institutional investor under Section 304 of the SFA, (ii) to a relevant person pursuant to Section 305(1), or any person pursuant to Section 305(2), and in accordance with the conditions specified in Section 305 of the SFA, or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. Macquarie Group, its employees and officers may act in different, potentially conflicting, roles in providing the financial services referred to in this document. The Macquarie Group entities may from time to time act as trustee, administrator, registrar, custodian, investment manager or investment advisor, representative or otherwise for a product or may be otherwise involved in or with, other products and clients which have similar investment objectives to those of the products described herein. Due to the conflicting nature of these roles, the interests of Macquarie Group may from time to time be inconsistent with the Interests of investors. Macquarie Group entities may receive remuneration as a result of acting in these roles. Macquarie Group has conflict of interest policies which aim to manage conflicts of interest. All third-party marks cited are the property of their respective owners. © 2017 Macquarie Group Limited INSIGHT-FTH 1710 (276625-10/17) This publication is intended for use only with institutional and professional clients. Not for public distribution.