After a slow start, central banks and global policymakers are now in the early stages of a coordinated response to the economic implications of the pandemic. We expect a combination of both monetary policy measures from central banks and fiscal stimulus measures from elected officials.
Lower rates and the return of QE?
We expect the Federal Reserve to cut the fed funds rate further, starting at the 18 March FOMC policy meeting. Further cuts will likely move the rate closer to the zero bound.
As a result, unconventional policy tools could come back into play including quantitative easing (asset purchases; QE) through balance sheet expansion. Currently, the Fed’s balance sheet as it relates to mortgage-backed securities (MBS) has been shrinking: about USD 20 billion in MBS runs off each month.
QE might target agency MBS
We believe this would be one area of the fixed income market for the Fed to reconsider for QE beyond further rate cuts. Stopping the run-off would add USD 20 billion in demand for MBS and reverse a source of monetary policy tightening.
Fixed income risk assets did poorly at the start of the year, with US investment-grade corporate bonds earning a negative 4.27% excess return, US high-yield credit -5.67%, and emerging market USD debt -5.05%. US agency MBS with its high credit quality and government backing has been a safe haven asset class, faring much better with an excess return of a more modest -1.04%.
MBS attractions stand out
We see the virus-driven growth slowdown continuing to have a much greater impact on corporate credit than on agency MBS. Ratings downgrades and default risk are rising and the risk premiums can continue to be pushed higher.
Relative to corporate credit, agency MBS offers a relatively safe yield, superior credit quality and far better liquidity and transparency. The current coupon nominal spreads on MBS are as wide as they have been in three years. Investment-grade corporate bond spreads had narrowed too far, and although they have widened recently, we believe they may need to widen by more.
Exhibit 1: Current coupon nominal spread and OAS – graph shows the difference (spread) between the yield on Fannie Mae’s 30-year bond (FNMA 30-year) and the 2-year US Treasury bonds (front UST) and the option-adjusted spread (OAS) between the FNMA30 and Libor
Exhibit 2: Nominal spread of investment-grade (IG) corporate bonds over US Treasury bonds, and the spread of the FNMA30 bond over front-end US Treasury bonds
Source for both exhibits: JPMorgan; data as of 10 March 2020
More on US MBS
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.