Now that the Federal Reserve has removed “patient” from its forward guidance, investors need to think about what this means for 1) the trajectory of short-term interest rates and 2) the potential exit strategies for the Fed’s $4.5 trillion in holdings of U.S. Treasuries, Agency debt and Agency mortgage-backed securities (MBS).
We believe that the answer to #1 will be highly data dependent, but that the pace of rate hikes will be slower and the equilibrium, or “neutral,” level of the federal funds rate will be lower than we are used to seeing in past interest rate cycles.
As for question #2, we believe the Fed will shift its focus to balance sheet reduction once the first rate hike is implemented, but likely will not actually sell bonds, in an effort to avoid creating a material disruption in fixed income markets. How can this be done? Amortization.
While the Fed ended net purchases of U.S. Treasuries and MBS in late 2014, it has continued to reinvest paydowns on its portfolio back into the MBS market. Given that the Fed owns $1.7 trillion in Agency MBS, it can end these reinvestments of monthly payments and become a “net seller” of bonds without ever conducting a sale. This may become a growing priority after ending ZIRP (the zero interest rate policy). Importantly, how the Fed ends reinvestments of MBS can have material implications for fixed income investors, especially considering that Agency MBS account for almost a third of the Barclays Aggregate Index.
Our base case is that the Fed tapers reinvestments, similar to the way in which it tapered its QE3 initiative. While a net negative for MBS supply/demand technicals, the impact would likely be gradual in this scenario.
The other option is to completely end reinvestments at once and immediately begin balance sheet reduction. While not our base case, this would be a material negative for Agency MBS valuations and is another reason to think twice before going overweight MBS. When we compare MBS valuations today relative to historical periods when the Fed was not in balance sheet expansion mode, they look expensive.
Bottom line – if the Fed ends its reinvestments, non-Fed MBS investors will need to absorb approximately $200 billion in new mortgages per year. We do not believe that private investors will provide this support at current pricing. Markets are forward-looking and will need to begin to prepare for this eventual reality.