Recent news from the US Federal Reserve that it will be reducing its bond purchases now worth USD 120 billion a month gradually, while it is in no hurry to raise policy rates any time soon has left a positive environment for US mortgage-backed securities (MBS) intact with attractive spreads over US Treasuries (USTs).
At its last policy meeting on 2-3 November the US Federal Reserve announced it would start the tapering of its large-scale asset purchase programme later this month by trimming UST purchases by USD 10 billion and MBS purchases by USD 5 billion a month. This was very much as expected in the markets and it means the Fed will continue adding MBS to its portfolio well into 2022.
Investors were given a well-orchestrated message on tapering by a Fed keen not to shock markets. While Fed chair Jay Powell did suggest the winding-down was open to change, with an optionality to accelerate the schedule, he made it clear that he would not want any decision to change the pace to surprise markets.
On inflation, Powell acknowledged that price increases have been more rapid than forecast, but reiterated that the inflationary factors were expected to be ‘transitory’. While US inflation is now above the Fed’s average inflation targets, the labour market is still healing from the shocks of the pandemic.
Despite substantial progress, the US economy is still missing five million jobs compared to pre-pandemic levels. We therefore believe the Fed, with its dual inflation and jobs mandate, is in no hurry to start raising interest rates.
Mortgage-backed securities are well placed
Overall, we see this as a good environment for MBS and we would overweight the sector versus UST. In our view, spreads are attractive and TBA dollar rolls [1] remain attractive in production coupons.
The move higher in yields has also moved mortgage refinancing rates higher. That should cause prepayments to start to slow, which will improve the carry in the MBS sector and temper refinancing supply.
We are entering the seasonal slowdown in housing market activity and this should also help slow prepayments.
Now that the Fed has officially announced its plans to taper, the risk of uncertainty should help alleviate concerns for MBS investors.
[1] A strategy to sell short MBS securities and to buy them back at a later date, providing the seller with cash to work with. TBA: to be announced. FNMA: Fannie Mae or Federal national Mortgage Association
