When the Federal Reserve starts cutting back on bulk bond purchases, mortgage traders are betting that their market will be at the forefront.
This would be a departure from the Fed’s balanced approach during its last pullback in 2014, when it slowed down purchases of Treasuries and mortgage-backed securities at the same pace. But with house prices now rising and loan rates near record lows, some are seeing the central bank have fewer opportunities to add $ 40 billion in mortgage bonds to its balance sheet every month.
This prospect is already causing fluctuations in financial markets as traders seek to get ahead of the Fed’s moves. Mortgage-backed securities lost 0.18% last month, although Treasury bonds were up, their lowest since the start of the pandemic in January 2020. Dallas Federal Reserve Bank President Robert Kaplan highlighted this view last week, saying he doesn’t think about the housing market and needs the same support it gets from the central bank.
“We don’t see any problems in the housing market that the Fed should be worried about – in fact, the opposite is true in certain parts of the country,” said Jake Remley, senior portfolio manager at Income Research + Management. which controls $ 90 billion and reduces the risks of those parts of the mortgage market that will be most affected by the Fed’s slowdown. “If the Fed is concerned about inflation and wants to do something, they should move away from mortgages and invest more in Treasury bonds.”
The Fed’s intervention in the housing market has long been controversial, although it began in 2008 after the collapse of the housing bubble that has plagued the industry for years.
This time, TheFed helped bring mortgage rates down to record lows. Real estate prices rose in line with Fed purchases, with home prices nationwide rising 13% in March from a year earlier, the highest since 2005.
To be sure, Fed Chairman Jerome Powell did not give any indication that the central bank would target the mortgage market, nor did he indicate when it would start cutting back on its debt purchases. But moving away from mortgage bonds will give officials more room to support the treasury market – just as President Joe Biden seeks to put in place major spending plans, including a national infrastructure program.
The Fed’s Treasury purchases helped pay interest on government debt over the past fiscal year, despite the fact that bond issuances skyrocketed to fund the fight against the pandemic. And Treasury Secretary Janet Yellen said low debt service costs would give the administration room to adopt its agenda. The Congressional Budget Office projects a $ 2.3 trillion deficit in fiscal 2021 after surpassing $ 3 trillion last year. This is the largest deficit compared to the size of the economy since World War II.
“This time around, the Fed will take a different approach,” said George Gonsalves, head of US macroeconomic strategies at Mitsubishi UFJ Financial Group. “It will be modulated. And given our fiscal deficit, it is the treasury market that needs the most support.
Rumors that the Fed may signal plans to adjust monetary policy in the coming months intensified on Thursday after new data showed that US consumer prices rose more last month than most economists had predicted. This has driven the 10-year break-even rate up, which in the bond market is a measure of the annual inflation expected over the next decade.
In addition to buying mortgages, the Fed adds $ 80 billion in Treasury bonds to its balance sheet every month. While he said he would maintain that pace, the minutes of his April meeting said a number of participants said it would be wise to discuss cutting it if the economy continues to “progress rapidly.”
Walt Schmidt, head of mortgage strategies at FHN Financial in Chicago, said the Fed could use one of its meetings this summer – or the August meeting in Jackson Hole, Wyoming – to begin talking about plans to slow bond purchases.
Post-pandemic purchases have boosted the Fed’s mortgage reserves to about $ 2.2 trillion, far more than in previous quantitative easing rounds. He focused on newly emerging mortgage debt, which helped lower the rate on 30-year fixed-rate loans to a record low of 2.65% in January. Net issuance of mortgage-backed agency securities more than doubled in 2020 from the previous year, reaching $ 508 billion, the highest level since the peak of the housing bubble in 2007.
However, not everyone is sure that the Fed will be the first to abandon the mortgage market. While this is one possible scenario, potentially allowing the central bank to focus on Treasury bonds, it is unlikely, says Alex Rover, head of US interest rate strategy at JPMorgan Chase & Co. follow his 2014 model.
“We think this is the path they are most likely to take because it’s the easiest way to communicate and doesn’t necessarily have any unintended consequences,” Rover said.
But Boston Fed President Eric Rosengren also spoke out last month to cut purchases of mortgage bonds faster than Treasuries when the time comes, because he didn’t see the sector need continued Fed support.
“There is a debate about the composition of the balance sheet regardless of the state of the housing market,” said former Fed Governor Randall Kroshner, who is now a professor at the Booth School of Business at the University of Chicago. “I think the Fed has the ability to ditch mortgage-backed securities faster than Treasury securities.”