The U.S. Federal Reserve has taken extraordinary steps to facilitate liquidity in capital markets. While these actions have begun to stabilize and normalize valuations, in the lowest risk “core” of the fixed income markets – trading of Treasuries and agency mortgage-backed securities (MBS) – issues still remain with risk transfer and liquidity.
We believe it is particularly critical to maintain stability and liquidity in core fixed income markets, or risk instability in assets further out the risk spectrum. A continuation of the Fed’s operations would likely stabilize this core and allow liquidity to more fully normalize. We see that as a necessary, but not sufficient step in the process of proper functioning in all areas of fixed income markets, including riskier credit and securitized products. All of these markets have an important function in the real economy, by facilitating credit for smaller and midsized business, housing and commercial real estate. Indeed, stabilizing the core is the first step in creating the most efficient and effective transmission of the easier monetary policy out into the real economy.
Recent rapid deleveraging by real estate investment trusts (REITs), hedge funds, volatility-targeting investors, and others caused meaningful spikes in realized volatility in assets that are generally deemed to be “risk free” due to their explicit or implicit government guarantee: U.S. Treasuries, Treasury Inflation-Protected Securities (TIPS), and U.S. agency MBS*. The rush to sell caused sharp and significant dislocations in valuations, leading to a substantial rise in margin requirements, in turn driving a need to deleverage, which further exacerbated market volatility and illiquidity. The Fed stepped in to thwart this vicious cycle via large-scale purchases of Treasuries and MBS, and valuations have since begun to normalize.
While valuations appear more normal now than in the past few weeks, not much else is normal in terms of the functioning of these markets. Aside from Fed operations, liquidity remains quite challenged, and low liquidity usually leads to more volatility, higher trading costs, and greater risk aversion – factors that can all contribute to reduced bank lending to the real economy. Given these realities, the Fed’s participation seems necessary for quite some time to normalize dynamics in normally liquid markets.
Several indicators of market functioning are still concerning. Here are some of the signals we are watching:
1. Valuations. Severe dislocations in the market prices of Treasury off-the-run bonds – bonds that aren’t the most recently issued – have subsided somewhat, but are far from levels that we would consider consistent with normal market pricing. Similarly, the yield spread between the current coupon mortgage and an equivalent maturity Treasury security – a measure of valuation – has declined, after reaching the highest level in modern times a few weeks ago. Nonetheless, these spreads remain quite wide. Furthermore, if you look at the entire mortgage index, not just the current coupon, valuations look more extreme. Continued Fed support across the entire Treasury curve and across the entire mortgage market should help normalize valuations and reduce mortgage rates for homeowners.
2. Daily volatility. As mentioned above, volatility across markets remains quite elevated, including intraday volatility. However, volatility in the mortgage market in particular, which tends to be lower than interest rate volatility during normal periods, is much higher now. Higher volatility decreases the amount of capital investors can dedicate to an asset class, leading to lower levels of liquidity. This in turn drives mortgage rates higher: Mortgage bankers need to raise the rate for homeowners, and investors require more yield to compensate for the higher risks of the asset. Strong and consistent support from the Federal Reserve can reduce volatility in these markets, which will also tend to lower mortgage rates for the homeowner.
3. Implied funding. The Fed has stabilized overnight interbank funding markets with massive injections of liquidity, but this additional bank liquidity has not benefited broader markets or investors. In the mortgage market, investors can raise cash with their MBS securities in what is called “the dollar rolls market.” The cost to raise cash in this market currently averages 80 basis points over the federal funds rate, when in normal times investors can raise cash at rates equivalent to or under the federal funds rate. Increased funding costs contribute to wider MBS spreads, which over time contribute to higher mortgage rates for homeowners. One other nuance that could make Fed purchases even more effective than they are is to settle their purchases in the front months, removing collateral and getting cash into the system sooner.
4. Supply. Treasury market supply is increasing and we expect it will continue to do so in the wake of the largest-ever stimulus bill that recently passed Congress. This massive amount of additional U.S. government debt will need to be issued during a time when the financial system has already been overwhelmed with risk aversion and increased demand for cash. We are also hopeful that mortgage origination will remain quite elevated as mortgage rates continue to decline. This would be a positive for the economy and mean the transmission mechanism of monetary policy is helping to lower mortgage rates, allowing more homeowners to access affordable lending rates. However, the Fed would likely need to continue purchasing Treasury and MBS for such positive market dynamics to materialize.
The bottom line
The Fed has moved aggressively to stabilize core assets, including Treasuries and mortgages. Yet these markets and a number of others remain dysfunctional and illiquid. Dampening volatility in Treasuries, mortgages, and TIPS is the first step to improving liquidity across a broader range of markets that hold important links to the real economy, and the ability of consumers and businesses to obtain credit. The Fed’s announcement on 3 April 2020 of their continued purchase schedule for MBS and Treasuries demonstrated that the Fed is listening and responding to ensure the proper functioning of liquid markets.
Please see PIMCO’s “Investing in Uncertain Markets” page for our latest insights into market volatility and the implications for the economy and investors.
Mike Cudzil is a generalist portfolio manager, Dan Hyman is head of agency MBS portfolio management, and Tiffany Wilding is an economist focusing on North America. They are regular contributors to the PIMCO Blog.