The Federal Reserve recently signalled that the time had come to start considering a scaling-back of its massive emergency support for the US economy as it recovers from the lockdowns and other pandemic-busting measures in a move that financial markets should have seen coming. Did they?
After last week’s meeting of the Fed’s Federal Open Market Committee, Chair Jay Powell made it clear that the committee is talking about tapering its billion-dollar asset purchase programme. We expect more details about the timing and sizing of the taper at upcoming FOMC meetings.
It has been widely anticipated that the Fed would to start the taper in late 2021 or early 2022. So Chair Powell’s comment should not have been market-moving news. However, premiums on mortgage-backed securities (MBS spreads; see exhibit 1) have been moving wider and the asset class has been underperforming.
The good news for MBS investors is that recent prepayment reports have finally showed signs of a slowdown due to higher loan origination rates and the fact that borrowers with an economic incentive have already refinanced their loans.
At 104.48, the average US dollar price of the MBS index remains at a significant premium to par. So slower prepayments should improve the carry in the MBS asset class.
As the Fed moves closer to tapering, we expect US interest rates to drift higher, moving mortgage origination rates higher. This should slow refinancing activity, which in turn should lead to less origination supply. We think this can help tighten MBS spreads.
For a 12-month scenario analysis on a range of interest rate and economic environments, we have assumed that the base case is no change in rates. This should allow our strategy to earn 3.41% against an MBS index return of 1.62%.
If rates rise by 25bp, the strategy still yields 2.71% and is positioned to outperform the index by 180bp. So, even in a rising rate environment, expectations are for a strongly positive absolute and relative return for the strategy.
On recent monetary policy developments, the market has been closely watching the Fed’s reaction as inflation pressures build. The central bank has called the recent rise in inflation primarily a function of the year-on-year base effect in comparing current prices to last year’s low levels during the lockdowns. The reopening of the economy has also created largely temporary bottlenecks and supply chain disruptions.
Last week’s FOMC meeting was, however, more hawkish than anticipated as Chair Powell remarked that inflation could end up being ‘higher and more persistent’ than expected. Notably, some Fed members brought forward their outlook for future rate rises, with some now seeing the first move in late 2022. Powell acknowledged the FOMC is actively discussing the tapering of the bond buying programmes.
After the FOMC meeting, global stock markets fell, the 10-year US Treasury yield moved higher and the MBS sector underperformed. In our view, the unusual curve flattening seen after the more hawkish Fed meeting was driven by technical conditions rather than by market fundamentals.
While it is true that commodity prices have come off the boil, they are still up sharply from pre-pandemic levels. The US growth outlook is improving and the labour market is making substantial progress. For now, it seems premature to call the end of the reflation trade.
The US has made great progress in the fight against the virus with upwards of 60% of the adult population now vaccinated. The economy is re-opening and gaining strength. The Fed is rightly moving towards removing emergency measures and extraordinary accommodation.
The first step, which we expect to be taken late in 2021 or early in 2022, is a tapering of the large-scale asset purchase programme. Talks about the taper are taking place, but we expect a long runway with clear communication from the Fed around the actual start of the tapering. Against this backdrop, we expect US yields to move a little higher and the yield curve to become a little steeper.
In a rising rate environment, the MBS asset class tends to outperform other fixed income asset classes due to its shorter duration and the benefits of slower prepayments and lower supply.
Unlike corporate or Treasury bonds, MBS are amortising assets with monthly cash flows. Each month, investors receive interest payments as well as scheduled and unscheduled principal repayments. These frequent, interim cash flows give MBS investors the opportunity to continuously reinvest capital as rates rise. This is a major difference from corporate or Treasury bonds.
While current nominal spreads on current coupon MBS are at about 90bp, we are neutral as we await further information from the Fed regarding the taper. Our bias is to overweight MBS in the event that there is market volatility around Fed taper news. We have a longer-term positive outlook on the sector.
We expect that as the Fed tapers and starts to unwind the extraordinary accommodation, rates will rise and prepayments will slow further. We have seen evidence of this already. In May, lenders reported that refinancing demand fell significantly across all loan types.
This is aligned with other data we are seeing. The Morgan Stanley Truly Refinanceable index, representing the percentage of borrowers with at least a 25bp incentive to refinance, is now at 50%, down from a peak at 80-90% in the second half of 2020 (see exhibit 2). Slower prepayments means better carry and less refinancing supply.
Contrary to fearing the taper, this would be a constructive environment for the MBS asset class.
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