13 Pub. 11 2022 Issue 3 Will the Federal Reserve Sell MBS? This question is likely to garner different responses, depending on whom you ask, and a plethora of caveats. It is a tough call for the Fed because stifling housing-related inflation without punishing everyday homeowners is a tricky task. For investors, this question matters a lot because the Fed’s cessation from active MortgageBacked Securities (MBS) purchases eliminated demand from the largest buyer in the market and had a punitive impact on MBS valuations. If the Fed starts actively selling into the market, that could exacerbate things even further. Why Sell? There is a solid case to be made for selling MBS because the Fed has repeatedly conveyed its desire to hold a portfolio of predominantly Treasury securities. It has already stopped active MBS purchases as part of Quantitative Easing (QE) and is allowing the amount of MBS that naturally runs off its portfolio through principal pay downs to increase over time. Unfortunately, this may not be enough to get to a Treasury-only portfolio. With mortgage rates nearly double the historic lows set over the past couple of years, virtually all existing mortgages have lower rates than those available today. As a result, refinance – and even purchase activity – has slowed dramatically. As high mortgage rates disincentivize people from refinancing and moving, mortgage balances are being paid down more slowly, and the resulting runoff of the Fed’s MBS balance sheet is happening more slowly as well. In fact, the maximum runoff caps set by the Fed to facilitate a gradual removal of its footprint likely will not even be reached through natural paydowns. The Fed announced plans to gradually and predictably reduce its securities holdings by setting caps on the amount of MBS and Treasury paydowns reinvested in those securities. This process began in mid-June with an initial monthly cap of $17.5bn MBS for the first three months, which shifts to $35bn/month in September. However, with prepayments slowing in response to higher primary mortgage rates, the Fed’s playdowns are already running below the planned maximum $35bn cap. In other words, organic MBS portfolio reduction will be much slower than the Fed wants. To make matters worse, the Fed’s Treasury holdings do not have this problem. The cap for Treasury securities was initially set at $30bn/month and shifted to $60bn/month in September. Because Treasury securities are not plagued by slowing prepayment activity like MBS, principal pay downs of Treasuries will be able to hit the full $60bn/month cap much more efficiently. This dynamic will cause the share of MBS in the Fed’s portfolio to increase relative to Treasuries rather than decrease. Additionally, a large part of the Fed’s targeted Consumer Price Index (CPI) measure considers rental and housing costs. In order to rein in inflation, shelter prices as a component of CPI need to come down. Over the long term, shelter prices in CPI tend to follow trends in home prices, which have yet to slow materially despite higher mortgage rates. This suggests shelter prices could remain strong until at least mid-2023. Thus far, the Fed has only attempted to control this by raising interest rates, but pervasively high shelter costs could put pressure on the Fed to take further action to bring down CPI. By Andrea F. Pringle, Financial Strategist, The Baker Group Continued on page 14
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