Speculation about the Federal Reserve’s (Fed) balance sheet — and specifically, what the future path towards its normalisation may look like — has been a popular topic in the news, Wall Street research and speeches by Fed members. The Fed’s total balance sheet stands at USD 4.2 trillion, of which USD 1.7 trillion is in mortgage-backed securities (MBS). The Fed views any reduction in the size of its balance sheet as monetary tightening, so to maintain the balance sheet at its current size it has been re-investing all US Treasury maturities and MBS principal pay-downs bought during its quantitative easing (QE) programme back into those sectors.
The release of the meeting minutes and member speeches following the March Federal Open Market Committee (FOMC) meeting shed light on the Fed’s potential tapering of its reinvestments. The minutes from the Fed’s May meetings were consistent with those in March. They indicated that balance sheet run-off may begin later in 2017 and conducted at a gradual and predictable pace so as to not overly influence spreads.
There were no further surprises from the recent June FOMC meeting. The FOMC announced initial caps in the amount of Treasuries and MBS that will be allowed to run off each month of USD 6 billion and USD 4 billion, respectively. Security repayments that exceed the caps will continue to be reinvested each month. The caps will be raised by these amounts on a quarterly basis until they reach USD 30 billion for Treasuries and USD 20 billion for MBS. The caps will remain at this level until the Fed’s balance sheet is normalised. The missing piece of information from the FOMC is timing. The relatively low starting level of the caps, as well as Chair Yellen’s comment in the press briefing that run-off could start ‘relatively soon’, suggest that the Committee is targeting a September start date.
Importantly, a steady state cap at USD 30 billion may still be binding on Treasury securities — in many months, Treasury maturities are markedly higher. So it is possible that the Treasury portfolio could eventually have a higher cap (USD 40–USD 50 billion), depending on how quickly the FOMC wants to right-size the balance sheet. As for MBS, a USD 20 billion cap would be more than sufficient — monthly portfolio pay-downs will average less than this over the next several years. There are reasons to keep this cap at a modest level. For example, if the economic outlook worsens and yields fall, prepayments on MBS that the Fed owns would increase. With a high cap, this scenario would lead to more rapid portfolio shrinkage (i.e., policy tightening) just when the outlook requires an easier policy stance.
We expect the FOMC to rely on changes to overnight policy rates as its main monetary policy tool, with balance sheet run-off happening on autopilot in the background. We thus see only limited scope for the FOMC to make more frequent adjustments to the run-off caps in response to economic conditions.
There could be two exceptions to this, however:
1) If the economic outlook suddenly worsens, the FOMC will quickly stop the balance sheet run-off. It would not make sense to continue tightening policy through the balance sheet when conditions suggest that policy easing — including QE — might soon be required.
2) If overall financial conditions do not tighten as the Fed withdraws policy accommodation, it could move to a faster pace of interest rate increases and portfolio run-off. There is certainly precedent for financial conditions to ease even as the FOMC raises rates. In the prior expansion, as the Fed raised rates beginning in 2004, overall financial conditions eased — longer-term interest rates stayed low, the dollar weakened, credit spreads tightened and equities continued to gain. Should this scenario repeat itself during the current tightening cycle, the FOMC may respond by speeding up the pace of balance sheet normalisation.
Note: Using baseline reinvestment tapering assumption of $2bn per meeting of additional runoff for MBS and USD 4 billion per meeting for Treasuries starting December 2017.
Source: J.P. Morgan, Federal Reserve, as of 31/12/16
We do not expect a major repricing of the MBS sector. It is our stance that many of the concerns have been reflected in the spread widening we have seen in the MBS sector late last year and so far this year. There are two types of supply in the agency MBS market: new home purchases and re-financings. The Fed has said it will taper the size of its balance sheet when rates have normalised. Higher rates mean fewer mortgage holders are incentivised to re-finance, meaning there will likely be significantly less issuance from re-financing. This implies that at the same time Fed demand is falling, MBS supply is also tightening. There should be some degree of equilibrium, although it is unlikely to be a perfectly smooth transition and we could well see some volatility and likely wider MBS spreads. Remember, though, that wider MBS spreads mean higher mortgage origination rates and in turn fewer prepayments and less supply.
Longer term, we think the MBS sector offers good value relative to other spread sectors. MBS performance has lagged that of other sectors as spreads have widened to reflect expectations of a decline in demand from the Fed later in the year.
It appears clear that the balance sheet reduction will be passive via run-off and would exclude outright asset sales. We expect a gradual rise in the term structure of US interest rates and a bias for slightly wider MBS spreads. Prepayment speeds should continue to slow in this environment so we favour higher-coupon, fixed-rate MBS and interest-only bonds. Reduced geo-political uncertainty should also help risk assets so we continue to look for an opportunity to overweight MBS versus Treasuries.
Written on 15 June 2017