The biggest structural change has been the Fed’s dominant presence. The central bank amassed as much as $1.78 trillion of MBS on its balance sheet under its quantitative-easing programs, which signaled to investors that it’s prepared to provide support if needed again.
The Fed’s actions have served to tamp down volatility for a market now in excess of $7 trillion. So much so that some investors worry the market is unprepared for the central bank’s withdrawal.
“We are developing a low-volatility addiction,” said Kirill Krylov, a senior portfolio strategist at Robert W. Baird & Co.
The Fed will allow its monthly MBS runoff to reach as much as $20 billion starting next month, part of an unwind that began in 2017. Policy makers have yet to announce long-term plans for the balance sheet, but some investors see a risk that more-aggressive deleveraging down the road could fuel volatility.
“Should the Fed decide to start actively reducing its balance sheet it will have very profound consequences in the mortgage market,’’ Krylov said. “The Fed has been buying the most negatively convex MBS. By not reinvesting its paydowns they will be poisoning the well by reducing the quality of the outstanding float.’’
The FHFA’s plan to combine mortgages from Fannie Mae and Freddie Mac starting next year is also fueling speculation that the quality of loans will decline and hurt liquidity.
Uncertainty also surrounds the GSEs, which aren’t meant to remain wards of the state forever. Changing their status doesn’t appear to be at the top of the administration’s priorities, and market participants doubt that any reforms would abandon the all-but-explicit government guarantee on agency-backed securities. But with a Trump-appointed director set to take over next year, the government could look to cede some of its role in mortgage markets to allow more private-label activity.
In the meantime, investors are focusing on whether the FHFA will loosen lending standards further, to put home ownership within reach of more borrowers as housing prices exceed pre-crisis levels in many areas.
While a rebalancing to allow more private-label issuance could be healthy, “there is a risk that the FHFA will become more open to a further relaxation of the credit box,’’ Krylov said.
This article was provided by Bloomberg News.