Investors brace for a flood of mortgage bonds as the Fed shrinks its balance sheet

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Investors are bracing for turmoil in the government-backed mortgage market as the Federal Reserve begins to outline its plans to shrink its $9 billion balance sheet.

There is an ongoing debate about how the US central bank will go about reducing its huge inventory of Treasuries and agency mortgage-backed securities (MBS). These were amassed over the past two years as the Fed sought to quell the financial panic stemming from the pandemic and protect the world’s largest economy from one of the worst contractions in history.

The Fed has pledged to reduce its holdings of Treasuries and MBS, and move towards a smaller portfolio entirely of Treasuries in a “predictable” way, but has not yet disclosed details on the timing and pace of a reduction.

Comments from senior officials and minutes from last month’s policy meeting suggest the central bank is in favor of selling its mortgage-related holdings outright rather than simply letting securities mature, a much more approachable approach. aggressive that investors believe could disrupt the market.

“If you were to try to execute something like this today, it would be pretty tough for the 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 retail investors are willing to absorb. Incoming supply could push prices down and boost yields, exacerbating a trend that began in November when the Fed began scaling back its monthly debt purchases. The effects could ultimately trickle down to other markets.

“The combination of mortgage and Treasury supply could and will likely continue to push up real rates, which will tighten financial conditions and impact risky assets,” Rieder said.

A boiling housing market last year — driven by low interest rates and high savings — pushed mortgage-backed securities issuance to a record high of around $4 billion, the data shows. from the Securities Industry and Financial Markets Association, with a net supply of approximately $900 billion.

But the Fed bought about two-thirds of that pool, leaving private investors to soak up about $300 billion. Without the Fed’s purchases, this year that figure would be around $550 billion, according to Vishwanath Tirupattur, head of fixed income research at Morgan Stanley.

“In a world where the Fed is not buying 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 supply shock should push prices down. Prices have already fallen as the Fed has since November reduced its purchases of Treasury bonds and MBS, its first step in tightening monetary policy to tackle the highest inflation in four decades.

The spread between agency MBS and treasury bills – the premium demanded by investors to hold the riskiest mortgage bonds over risk-free treasuries – widened from 0.02 percentage point in early November to 0.32 percentage points today, the highest level in over a year. .

This decision must go further, according to investors, in order to fully assess the upcoming offer.

“The calculations are daunting,” said Michael Khankin, head of RMBS research at Barclays, who thinks mortgage spreads could widen another 0.15 to 0.20 percentage points.

The Fed should be very 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 minimize the impact.

“The question is not just whether they should make sales, but if they should make sales, how could they do it in a way where the sales themselves would have the least impact on the market,” he said.

“The Powell Fed is trying to avoid surprises,” Roever added. “They’re trying to communicate an idea to the market before they do anything substantial.”

Not all investors are worried about the effects of Fed tightening on the MBS market. While the housing market has been in turmoil since the Fed cut interest rates to zero at the start of the pandemic, annual issuance in the agency MBS market has averaged around $1.6 billion. in the 20 years before the pandemic, compared to $4 billion in 2021. If issuance this year returns to more normal levels, that could offset the effects of Fed tightening.

“If the Fed decides to sell, that’s definitely a negative, but that’s only one factor,” said Daniel Hyman, head of MBS portfolio management at Pimco.

“Because they’ve written down a lot already,” Hyman said, the company went from a significantly underweight position in agency MBS last year to a much more underweight position this year.

“If you’re planning anything on housing, don’t look at the past two years as the base case. It was so abnormal,” said Ben Schweitzer, portfolio manager at Ellington Management Group.

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