This month when the US Federal Reserve begins its balance sheet normalization — part of a quantitative tightening process the Fed has been signaling since early 2017 — some are anticipating that this shrinking of the balance sheet could create risks for the mortgage market. The concerns stem from the amount of mortgage-backed securities (MBS) that the Fed owns — totaling more than a quarter of the $6.86 trillion agency MBS market (source: Bloomberg). The Fed bought much of these securities to prop up the US housing market after the global financial crisis.
However, in our view, the record of quantitative easing (QE) since the financial crisis may tell a somewhat more positive story. Given the historical backdrop, we believe that the Fed tapering alone is unlikely to lead to widening MBS spreads in the near term, and a gradual tapering could mean only marginal headwinds for the MBS market longer-term.
Fed reinvestment in the near term
As the Fed has indicated, it plans to start shrinking, or running off, the reinvestment of Treasury maturities and agency MBS principal paydowns by $6 billion and $4 billion a month, respectively. The run-off amounts (caps)will be evaluated quarterly, and, depending on economic conditions, the intention is to increase them until the caps reach $30 billion for Treasurys and $20 billion for agency MBS. If the economic outlook deteriorates, the Fed has indicated it is prepared to resume reinvestments or alter the size and composition of its balance sheet, in addition to lowering the federal funds rate.
The ultimate future size of the balance sheet is unknown, but it will likely be significantly larger than the pre-2009 range of $800 billion to $900 billion. Estimates for the terminal size range between $2.5 trillion and $3.0 trillion, compared to the $4.5 trillion currently held. A higher gross domestic product (GDP) and more currency in circulation help support the notion of a larger balance sheet.
While the gradual cap approach will determine the actual run-off, the amounts of Treasury maturities and agency MBS paydowns will determine the size of remaining reinvestments. Year to date, the Fed has been reinvesting $16 billion a month in Treasurys and $23 billion a month in agency MBS, on average. As the charts below show, over the next six to nine months, the Fed is expected to continue to purchase similar amounts of Treasurys and about $10 billion a month of agency MBS, on average. The Treasury maturity schedule will significantly increase in the first half of 2018, while estimated agency MBS paydowns remain elevated in the near term.
The ebb and flow of reinvestment amounts of agency MBS and Treasurys are likely to lead to relative performance differences between the two asset classes, as the chart below indicates. Over the short term, agency MBS are likely to outperform, while during the first half of 2018, as the amount of Treasury maturities increase, Treasury reinvestments are expected to surpass agency MBS.
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.