With better communication from the Federal Reserve (Fed), John Kerschner explains why mortgage-backed securities (MBS) may actually benefit from tapering if they are favored over “riskier assets.”
- The Fed will soon begin to taper its purchases of U.S. Treasuries and MBS.
- We think the Fed learned its lesson from the 2013-2014 “taper tantrum,” and efforts to better communicate its intentions have paid off. With a sense of what is coming, volatility has been negligible.
- MBS may actually benefit from tapering if they are favored over risk assets, including corporate bonds, as the tapering process unfolds.
Substantial fiscal and monetary support for the U.S. economy in 2020 broke all records and, in our view, set new precedents for intervention in the financial markets by the Federal Reserve (Fed). But a lot has changed in a year. Both macro and microeconomic fundamentals have improved, corporate bond markets have rallied toward historical spread lows and securitized products have recovered broadly, while the Fed has recently confirmed it will begin tapering asset purchases from November 2021. What effect will reducing the current pace of quantitative easing have on credit markets generally, and the mortgage market specifically?
The Fed Was Aggressive in 2020
Before COVID-19 struck, the Fed owned about 23% of outstanding agency mortgage-backed securities (MBS)1. As COVID spread, the Fed started buying agency MBS and Treasuries in the open market to provide liquidity to financial institutions and to help lower mortgage rates. While the liquidity provided short-term medicine, lowering mortgage rates was a longer-term strategy to provide consumers the opportunity to refinance their mortgages at cheaper rates, thereby putting more disposable income in their pockets. The strategy worked. Mortgage rates plummeted as U.S. Treasury yields fell, refinancing spiked2 and the Fed aggressively bought the new mortgages.
Today, the Fed owns about 31% of the outstanding agency MBS market, or approximately $2.5 trillion3 – and is still buying. Estimates vary, but it seems likely it will end up owning around 40% of the market before reaching the point where the volume it is buying is lower than the rate at which the holdings mature – that is, paid off or prepaid as homeowners refinance or move. Regardless of where that point is, it is less of a concern to the market than how the Fed plans to ultimately reduce its exposure.
Fed Holdings of Agency MBS
Source: Bloomberg, as of 30 September 2021.
The Market Remembers 2013-14
The Fed had a smaller scale MBS and Treasury purchasing program during the Global Financial Crisis (GFC). Unfortunately, the attempt to taper those purchases was something of a debacle. When the markets caught wind that Treasury purchases would slow, 10-year yields spiked around 1.0% in just a few months4. The period came to be known as the “taper tantrum,” which in our view was due to a failure in communication. In 2013, caught by surprise, the markets leapt to a worst-case conclusion as the Fed failed to sufficiently communicate its intentions in advance and give markets time to digest the plan.
We think the Fed has learned its lesson and been much more intentional about telegraphing its thinking, in advance. Since June, the Fed has been signaling that it will take the process in steps. After the September meeting, Chair Jerome Powell indicated that tapering bond purchases could begin as soon as November, and on 4 November he was clear that it would indeed begin this month, with a $5 billion monthly reduction in purchases of MBS5.
We think the central bank would like to get back to owning closer to 20% of the market, near the level held pre-COVID, and is unlikely to lower its holdings to zero; purchasing MBS has proved a useful tool for supporting the economy and moderating market volatility in times of stress.
Given the volume of bonds currently owned and being purchased, we expect the Fed’s tapering will last less than a year – but getting the size of the MBS portfolio to its target could take a few years. To be clear, we do not expect the Fed will ever sell MBS outright in the open market – which could raise justifiable supply concerns, rather, it could instead buy fewer bonds over time while letting the ones it holds mature or prepay.
Tapering, Without the Tantrum
The Fed deserves credit for learning from its mistakes and being willing to first “talk about talking about” plans to both raise interest rates and taper bond purchases. Today, we believe most of the potential widening in MBS spreads due to tapering has already taken place. However, withdrawing liquidity from the MBS and Treasury markets could have a greater impact on corporate bonds and other “risk assets” broadly. If riskier assets do see spread widening as the Fed withdraws liquidity, we think investors may find MBS’ approximately 0.9% yield advantage over Treasuries (while carrying the same credit rating) attractive6. Conversely, if a reduction in the Fed’s purchasing of Treasury securities causes Treasury yields to rise (even if orderly), this would raise mortgage rates commensurately, thereby lowering the speed at which they would prepay – another positive for MBS as an asset class in the coming quarters.
In the long run, is the Fed likely to provide the same, or even more, support to the MBS market should another crisis occur? History would suggest the answer is “yes.” We would expect the Fed to ramp up its MBS (and Treasury) purchases as these are ideal assets for the Fed to own given their high credit quality. It may also help that the Fed does not need congressional approval to buy Treasuries or MBS while it is seen as more controversial for them to be using its powers under the Federal Reserve Act to buy the bonds of corporations.
Short-term or long-term, we believe MBS securities are likely to fare relatively well. MBS are likely to weather the remains of the most recent storm, and the Fed’s well-telegraphed tapering. And we believe MBS are expected to be supported by the Fed whenever the next storm comes. For investors seeking diversity from corporate bonds in the current environment, we believe agency MBS deserve a closer look.
1 Bloomberg, as of 30 September 2021.
2 Between 21 February and 6 March, the U.S. Refinancing Index rose more than 200%. Bloomberg, 31 August 2021.
3 Bloomberg, as of 30 September 2021.
4 Bloomberg, as of 30 September 2021.
5 Remarks by Chairman Jerome Powell as reported by CNBC, as of 4 November 2021.
6 Bloomberg U.S. MBS Index, as of 30 September 2021.