January 12, 2014
Over the next 3-6 months, the Bull (FED) in the china closet will leave its mark somewhere. For those that remember the Merrill lynch commercials with the bull walking around a glass museum and not breaking anything, this is somewhat similar. Except that this is reality and that changes everything. The Fed has been the biggest buyer in the world of US Treasury and agency MBS securities. As they depart the bond store, they will leave an impact. This week I am focusing on the MBS market.
Over the next 6-8 months, assuming the Fed decreases its purchases by $10 billion a month or $20 billion a quarter, then we can safely say that the Fed’s balance sheet of MBS and Treasury securities will continue to grow. This means, for the MBS market, that spreads will be highly volatile. Since announcing the QE 3 program in September 2012, the Fed has bought about $1.05 trillion agency MBS and increased its MBS holdings by $675-$680bn (after accounting for pay-downs). As of year-end 2013, I estimate that the Fed owned $1.53 trillion agency MBS out of the total agency MBS market size of about $5.40 trillion. If the Fed continues with its tapering plan and ends its QE 3 program altogether in October 2014, they are likely to be a net buyer of an additional $200-$215bn agency MBS (from Jan-Oct’14). In this scenario, the Fed is likely to own about 39% of all outstanding agency MBS passthroughs (all agency MBS outstanding - CMOs) by the time the QE 3 purchases are completed. In fact, the Fed is going to own about 51-52% of all 30-year FN/FH passthroughs alone. Further, the figures estimate that the Fed and domestic banks together are likely to own close to 70-72% of all 30-year FN/FN MBS passthroughs (excluding CMOs). Considering that a significant portion of active trading in agency MBS occurs in 30-year mortgages, the traditional spread based investor has been facing enormous challenges and will face even more in 2014. Without the Fed’s purchases, the market will be flooded with agency MBS, but selling too soon could cause near-term performance issues. The numbers indicate that the volume of agency MBS available for active relative value trading is going to be extremely limited by the middle of 2014. While agency MBS spreads look very tight versus Treasuries , investors need to be nimble and precise on their allocation, otherwise they may underperform their bogey.
Why am I nervous, since we do not dabble too much in agency MBS? I am a believer in Newton’s laws of (e)motion. Every action has an equal and opposite reaction. And, I believe, every action has consequences. If agency MBS is tight but could get tighter, which increases negative convexity, then will these investors rush to the Agency callable market? YES! The FED plays games, we the investors, pay the price. Somewhere, sometime in 2014 it will get wild and crazy, and we will need to keep a keen eye on spreads, because we want to be on the right side of that “opposite reaction”.