Mortgage bonds pose big questions for the Fed as it begins to shrink its balance sheet. Here’s why.

The Federal Reserve is about to start unwinding its balance sheet for the second time after the financial crisis, but this time the process will start sooner.

The time of dreams

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The Federal Reserve is about to start shrinking its massive balance sheet. Officials say the process will happen in the background, but it probably won’t. Investors should prepare for a long period of uncertainty and volatility.

When the central bank released the minutes of its March meeting last week, it suggested that in May it would begin unwinding some of the trillions of dollars in pandemic bond purchases it made in the United States. over the past two years. That would be lightning fast, given that quantitative easing has just ended. The last time the Fed did quantitative tightening, or QT, it waited two years after raising interest rates to shrink its balance sheet. His newly suggested plan would amount to a double policy tightening, half of which investors may miss.

We know policymakers would have raised rates half a point in March if Russia hadn’t invaded Ukraine, and the minutes of the meeting and the recent Fedspeak suggest that many officials are in favor of at least minus a 0.5% increase in future meetings. According to data from the CME, traders are pricing an 80% chance of a half-point hike in May and a 50% chance of another in June.

But QT isn’t even close to being valued in the markets, says Peter Boockvar, chief investment officer at Bleakley Advisory Group.

It makes sense that more attention is paid to rates than to balance sheet reduction. While economists, market analysts, and business executives can easily model changes in interest rates, QT has only happened once before. And, as Boockvar notes, it happened at freezing speed. Investors have new details on how the Fed intends to manage its $9 trillion portfolio — which has doubled since the start of the pandemic and accounts for about 40% of gross domestic product — but how it ripples on the economy and the markets is the big unknown.

As Fed Chairman Jerome Powell said earlier this year, “I think we have a much better idea, frankly, of how rate hikes affect financial conditions and therefore economic conditions. [The] The balance sheet is still a relatively new thing for the markets and for us, so we are less sure.

Here’s what we know so far: The Fed has signaled that it will let its balance sheet shrink by $60 billion in Treasuries and $35 billion in mortgage-backed securities per month, to reach that pace over three months. He will let these maturing securities roll over, instead of reinvesting the proceeds.

It’s pretty easy on the Treasury side of the portfolio, at least for next year. Boockvar notes that about one-fifth of the Fed’s $5.8 trillion Treasury securities mature in a year or less, and about 30% of that share will do so in less than three months. And Barry Knapp, research director at Ironsides Macroeconomics, says the roughly $4 trillion in bank deposits and an additional $2 trillion in central bank cash means it will take at least a year to absorb the excess cash.

It’s much trickier on the mortgage-backed securities side. Part of the problem: As rates go up, prepayments go down. This lengthens the duration of the Fed’s MBS holdings, limiting natural short-term runoff. In November 2021, the contingent prepayment rate was around 30%, according to data from S&P Global. If prepayments slowed to a 10% rate – as they did at the height of the 2017-19 tightening cycle – MBS runoff would average around $20 billion a month, the chief economist says. of Jefferies, Aneta Markowska. That’s well below the $35 billion cap announced by the Federal Reserve, and means it would need to sell about $15 billion of mortgage-backed securities per month to hit its target.

Not so long ago, the idea that the Fed would sell MBS was shocking. Now Wall Street thinks outright selling won’t happen until 2023 at the earliest; Boockvar says it will be much sooner.

Here’s what else we know about QT. While rates affect demand more directly, quantitative trades affect asset prices more directly. QE significantly boosted these prices when the Fed bought, and investors should expect a symmetrical outcome with QT, although the Fed is not fully reversing its pandemic buying. Boockvar says that every trillion dollars of QT equates to about 0.5% more crunch. But how far will stocks and house prices fall? Nobody seems to know.

Among the other known unknowns, here are a few to ponder:

When the Fed sells MBS, there will be buyers including banks, insurance companies and pension funds, says Joseph Wang, a former senior trader in the Fed’s open markets office. But he notes that over the next few years, about $2 trillion of QT will overlap with historically high Treasury issues. This means a lot more supply for investors to absorb, even ahead of MBS sales. And, adds Wang, recent fund flows suggest a drop in demand for Treasuries. “Even the most ardent bond bulls won’t have enough money to absorb the flood of issuance, so prices have to come down to attract new buyers,” he observes. So how low should prices go and how high should yields go?

Then there is the impact on housing. How the Fed handles the unwinding of MBS is crucial to what happens to the overall economy. The central bank needs to cool the housing market, which accounts for 40% of consumer price inflation and a fifth of GDP. But what happens when demand slows but prices continue to rise due to low inventory?

And finally, when the central bank sells MBS, it is likely to do so at a significant loss. Who will eat it?

Last week, the Fed released more details on the QT than many strategists expected. But there are still more questions than answers, with investors and policymakers together in the dark.

Write to Lisa Beilfuss at lisa.beilfuss@barrons.com

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