Investors are bracing for turmoil in the market for mortgage loans backed by the government as the Federal Reserve begins to sketch out its plans to shrink its $9tn balance sheet.
A debate is under way about how the US central bank will go about reducing its enormous stock of Treasuries and agency mortgage-backed securities (MBS). These were amassed over the past two years as the Fed sought to quell financial panic stemming from the pandemic and shield the world’s largest economy from one of the worst contractions in history.
The Fed has pledged to reduce its holdings of both Treasuries and MBS, and to move towards a smaller all-Treasury portfolio in a “predictable manner”, but has yet to divulge any details about the timing and pace of a reduction.
Comments from top officials and minutes from last month’s policy meeting suggest there is support for the central bank to sell its mortgage-related holdings outright rather than simply allowing the securities to mature, a far more aggressive approach that investors warn may roil the market.
“If you were to try and execute something like that today it would be pretty hard on markets,” said Rick Rieder, chief investment officer of global fixed income at BlackRock.
Even without active selling, investors fear the market could be flooded with more mortgage bonds than private investors are prepared to absorb. The incoming supply could drive prices lower and yields higher, exacerbating a trend that started in November when the Fed began reducing its monthly purchases of debt. The effects could ultimately spill over into other markets.
“The combination of mortgage and Treasury supply could and probably will continue to move real rates up, which will tighten financial conditions and impact risk assets,” said Rieder.
A hot housing market last year — driven by low interest rates and high savings — pushed issuance of mortgage-backed securities to an all-time high of about $4tn, according to data from the Securities Industry and Financial Markets Association, with a net supply of about $900bn.
But the Fed bought up roughly two-thirds of that pool, leaving private investors to absorb about $300bn. Without the Fed’s purchases, this year that figure is slated to rise to roughly $550bn, according to Vishwanath Tirupattur, head of fixed income research at Morgan Stanley.
“In a world where the Fed doesn’t buy anything, private investors will have to absorb a significantly higher amount of supply than last year,” said Lofti Karoui, chief credit strategist at Goldman Sachs.
The shock of supply is likely to drive prices lower. Prices have already fallen as the Fed has since November reduced its purchases of both Treasury bonds and MBS, its first step in tightening monetary policy to combat the highest inflation in four decades.
The spread of agency MBS over Treasuries — the premium investors demand to hold the riskier mortgage bonds over risk-free Treasuries — has risen from 0.02 percentage points at the beginning of November, to 0.32 percentage points today, the highest level in more than a year.
That move has further to go, investors argue, in order to fully price in the supply to come.
“The math there is daunting,” said Michael Khankin, head of RMBS research at Barclays, who thinks that mortgage spreads could widen by an additional 0.15 to 0.20 percentage points.
The Fed is expected to be highly sensitive to any adverse market reaction stemming from its balance sheet plans, and according to Alex Roever, head of US rates strategy at JPMorgan, will seek to minimise the impact.
“The question is not just about whether they should do sales, but if they were going to do sales, how could they do it in a way where the sales themselves would have the least market impact,” he said.
“The Powell Fed tries to avoid surprises,” Roever added. “They try to communicate an idea to the market ahead of doing something substantial.”
Not all investors are worried about the effects of the Fed’s tightening on the MBS market. While the housing market has been sizzling since the Fed cut interest rates to zero at the start of the pandemic, annual issuance in the agency MBS market averaged about $1.6tn in the 20 years prior to the pandemic, versus $4tn in 2021. If issuance this year returns to more normal levels, that could offset any effects of Fed tightening.
“If the Fed decides to sell it is a definitive negative, but it is only one factor,” said Daniel Hyman, head of agency MBS portfolio management at Pimco.
“Because they have already cheapened a lot,” Hyman says the firm has moved from a large underweight position in agency MBS last year to a much smaller underweight position this year.
“If you’re projecting forward anything with regards to housing, don’t think of the last two years as the base case. It was so abnormal,” said Ben Schweitzer, portfolio manager at Ellington Management Group.