The timing and pace of the Federal Reserve’s forthcoming move to reduce monthly purchases of Treasuries and agency mortgage-backed securities (MBS) has become a topic of daily conversation in the financial markets. From the Fed’s perspective, this is by design an effort to provide sufficient transparency such that the markets’ reaction function is smooth. Hence, Chairman Powell’s present contribution to the lexicon of Fed speak, “we are talking about talking about tapering.” Even Chairman Greenspan has to admire that one.
From the market’s perspective, the high level of attention is a natural reaction given the disruptive impact of the initial taper after the global financial crisis. Needless to say, a 100-basis-point move in the 10-year Treasury yield today would have a severe impact on asset values in current markets, and there is no expectation of a replay based on the widely held view that the Fed will modulate its path to avoid such an outcome. While the market debates and postulates the policy path and the consequent rate effect, what gets somewhat overlooked is the relationship between Treasuries and mortgages. One third of the Fed’s monthly net purchases of $120 billion is in the agency MBS market, and policymakers have indicated that the unwind will be proportional.
The agency mortgage market is currently trading roughly 15 basis points rich relative to its three-year average, and our expectation is that the average is a reasonable target as to where we go when the taper commences, with a maximum potential move of 30 basis points. Record-low rates and a booming housing market have produced well over $1 trillion in net issuance in this market since the onset of the pandemic, with the Fed absorbing a substantial portion. Also somewhat unique for early-cycle has been large buying by the commercial banks, which have sailed through the crisis with capital and ratings intact, and with wide open capital markets providing for the bulk of private borrower needs.
In the recent Treasury rally from May through last week, agency mortgages only captured about half of the Treasury move, leading us to tactically sell Treasuries and buy MBS with the belief that a rate pullback would reverse some of that change. In the event of any widening related to tapering, our response will likewise to be a more enthusiastic buyer.
Agency passthroughs are a foundational asset in most of our investment grade and multisector bond portfolios. Today, these exposures are generally somewhat below their long-term average. We look forward to the Fed’s exit, which should allow a bit more value to return to this important market. To paraphrase the old song, don’t fear the taper, but seek to use it to your advantage.
In Case You Missed It
- U.S. Consumer Price Index: +0.5% in July month-over-month and +5.4% year-over-year (core CPI increased 0.3% month-over-month and 4.3% year-over-year)
- U.S. Producer Price Index: +1.0% in July month-over-month and +7.8% year-over-year
- U.S. Initial Jobless Claims: +375,000 for the week ending August 7
What to Watch For
- Monday, August 16:
- Japan 2Q 2021 GDP (Preliminary)
- Tuesday August 17:
- Eurozone 2Q 2021 GDP (Second Preliminary)
- U.S. Retail Sales
- NAHB Housing Market Index
- Wednesday August 18:
- U.S. Housing Starts and Building Permits
- FOMC Minutes
- Thursday August 19:
- U.S. Initial Jobless Claims
- Japan Consumer Price Index
– Andrew White, Investment Strategy Group