While most Fed watchers are focused on what the policymakers will do with the federal funds rate, a more interesting topic may be the so-called “FedTrade,” which is keeping certain agency mortgage-backed securities’ risk spreads at artificially low levels. But what happens when the Fed decides to stop?
Under FedTrade, the Fed purchases agency mortgage-backed securities on a daily basis, which helps keep mortgage rates low, thereby promoting homeownership and home-price appreciation.
With this so-called FedTrade, the Fed has purchased pools of mortgages that have current coupons (3.0%, 3.5%, and 4.0%). These large-scale asset purchases have affected the valuations of 30-year agency mortgage-backed securities, as the chart below illustrates. These purchases have supported the prices of mortgage-backed securities with the goal of keeping mortgage rates lower than they might have been otherwise.
As you can see, there is very little compensation, as measured by option-adjusted spread (OAS), or risk spread over U.S. Treasuries, in the mortgage pools that the Fed has purchased. This is how the Fed has manipulated mortgage rates to remain at lower levels.
The big question is what will happen when the Fed decides to stop purchasing agency mortgage-backed securities, allowing mortgage rates to be determined by private investors. There is a rich debate occurring about whether the Fed will need to sell securities from its balance sheet, and any decision to sell securities—or even a market expectation that the Fed will sell securities—could result in more broad-based volatility.
Regardless, we expect that when the Fed decides to end FedTrade, current-coupon mortgage spreads will increase by 10 to 25 basis points versus U.S. Treasuries.
Where does that leave fixed-income investors? According to a recent survey, primary dealers expect FedTrade to end in early 2018. We believe that is a reasonable estimate. Regardless, we invest in none of the current-coupon mortgage pools I mentioned above that the Fed has purchased.
These current-coupon mortgages have longer durations and unattractive valuations; higher-coupon pools offer more attractive risk spreads and higher income. In fact, we have the ability to hedge interest-rate risk through mortgage TBAs, or “to be announced,” which track those current-coupon pools by selling them forward.
In another post, I’ll discuss a metric we can use to help gauge the risk of the end to the FedTrade.