Should the Fed Buy Treasuries or Agency MBS During QE? Yes

Should the Fed Buy Treasuries or Agency MBS During QE? Yes

The U.S. Federal Reserve announced on 16 September it would continue its current mortgage and Treasury purchase programs and keep the federal funds rate on hold until inflation sustainably exceeds its 2% target – all keys to containing interest rates at very low levels. The bond-buying programs began in mid-March as the central bank took unprecedented steps to shore up the most liquid markets and thereafter support subdued economic activity amid the pandemic-driven recession.

To date, the Fed has purchased more than $3 trillion in U.S. Treasuries and $1 trillion in agency mortgage-backed securities (MBS), and Wednesday’s meeting reaffirmed its commitment to continue purchasing $80 billion in U.S. Treasuries and $40 billion in agency MBS (net of reinvestments) per month for the foreseeable future. The Fed and market participants have debated whether it should simply choose one tool or another, and if the time to slow the pace of purchases has arrived. In our view, each of these tools helps the Fed satisfy its dual mandate of price stability and full employment by supporting fiscal policies and moving investors out the risk spectrum (for background on the risk spectrum since the COVID crisis began, read “A Phased Market Recovery as Liquidity and Fundamentals Return”). Therefore, we believe the Fed was right to continue both Treasury and MBS purchases.

Narrowing the spread

While it would be difficult for the Fed to ease financial conditions by lowering Treasury rates further, there remains substantial room within the agency MBS market to narrow spreads. Indeed, MBS purchases remain an important tool within the Fed’s toolkit, and we believe the purchases should continue as long as the Fed wants to expand its balance sheet and bolster economic activity via the housing market. If the Fed were to purchase Treasuries without also buying MBS, Treasury rates could stay low while mortgage rates could come down much less, or even move higher. (Recall that before March, the Fed was buying U.S. Treasuries and selling MBS, widening spreads and raising mortgage rates.)

The room for improvement in the spread can be seen clearly within Figure 1, which compares the 30-year mortgage rate to the 10-year Treasury rate. For the most part, the fall in Treasury rates has not been passed on to homeowners; however, we are seeing this spread decline with each passing month the Fed remains involved, and more can be done. Additional incremental Fed purchases of MBS would send a strong signal to markets and could lower mortgage rates more quickly, accelerating the timeline of getting lower mortgage rates to homeowners.

This line graph shows the spread between the 30-year U.S. mortgage rate and the 10-year U.S. Treasury rate over the period from January 1, 1999 through August 28, 2020. The spread has generally ranged between 1 and 2, but it climbed sharply in 2007 and 2008, peaking at 3.2 in December 2008, before returning to a general range of 1.5 to 2. In mid-2019, the spread began to climb again, reaching 3.2 in April 2020. It’s come down a bit since then. As of August 28 (the last data point in the chart), the spread between the 30-year mortgage rate and the 10-year Treasury rate was 2.4. The data was sourced by Bloomberg.

Targeting homeowners, and buyers

Lower mortgage rates should allow more people with higher mortgage rates to refinance and more people who are uneconomically renting the opportunity to buy a home (see Figure 2). While a refinancing wave began in late March, it has been gradual. Currently, less than 4% of homeowners have mortgages at today’s rates. Fed participation for the foreseeable future would allow originators to expand capacity, eventually allowing for the possibility to lower mortgage rates further and granting millions access to those low rates.

This line chart shows the ratio of the cost of buying a home to the cost of renting in the U.S. over the period from the start of 1993 through September 9, 2020. The ratio of buying a home generally ranged from 0.9 to 1.3 times that of renting until 2006, when it began climbing, reaching 1.7 in 2007. It has been declining since then, and as of September 10, 2020, the cost of buying a home was 0.5 times, or half the cost of renting. Chart sources are Freddie MAC, the Census Bureau, and PIMCO as of 9, September 2020.

Over long periods of time, mortgage rates relative to Treasury rates tend to stabilize, but in any given period of time this relationship can dislocate. We believe the Fed’s continued purchases remain a necessary and powerful tool to normalize this relationship and allow a seamless transmission mechanism of monetary policy to occur.

For more educational resources, please visit PIMCO Investor Education Resources.

Mike Cudzil is a generalist portfolio manager, and Dan Hyman is head of agency MBS portfolio management. They are regular contributors to the PIMCO Blog.

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