For all the talk that Janet Yellen’s plan to shrink the Federal Reserve’s balance sheet will hurt Treasuries, U.S. mortgage bonds face a bigger test.
The securities are already lagging behind Treasuries for the first time since 2011. Investors are demanding 29 basis points of extra yield to buy the bonds instead of Treasuries, with the spread almost tripling from 2016’s low, Bloomberg data show. Firms including Allianz Investment Management and Federated Investors say the spread widening probably isn’t over.
“The market will be able to digest it, but you’ll need a higher yield to make buyers buy it,” said Marc Fovinci, head of fixed income at Ferguson Wellman Capital Management Inc. in Portland, Oregon, which handles $4.8 billion. “The pace Yellen is talking about, it won’t be like flipping the light switch off. It’ll be like turning the dimmer switch down” on investor demand. The spread will probably double in a year, Fovinci said.
The Fed owns more than a quarter of the $6.86 trillion in agency mortgage-backed securities, and its holdings are likely to dwindle to almost nothing at some point because it only bought the securities as an emergency measure to prop up U.S. housing in the last recession. The Fed holds 18 percent of the publicly traded Treasuries market, and it’s likely to ultimately keep more of those holdings as part of its monetary policy arsenal.
The Fed’s effort to trim its balance sheet will mark the beginning of the end to its historic effort to gobble up mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae, concluding a program that created money for these companies to funnel into U.S. home lending.
Ben Bernanke, Yellen’s predecessor as Fed chief, began the purchases in January 2009 following a surge in mortgage spreads that pushed the differential over Treasuries to more than 190 basis points at the end of 2008. The figure was as low as 33 in January 2007, before the global financial crisis.
The Fed concluded its asset purchases in October 2014, though it kept reinvesting the principal repayments to keep the total size of its holdings steady. Now the central bank says it plans to begin trimming its balance sheet “ relatively soon” by cutting back on those reinvestments. The Fed intends to start off with with monthly reductions of $6 billion of Treasuries and $4 billion of mortgage securities, and gradually increase the amounts to $30 billion and $20 billion respectively.