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.

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Please carefully consider the Funds’ investment objective, risks, charges, and expenses before investing. This and other information is contained in the Funds’ prospectus, which you may obtain by calling +1 800 742 7272. Read it carefully before you invest or send money. Investing includes the risk of loss.

Any statements or opinions expressed are those of the author as of the date of publication, are subject to change without notice as economic and markets conditions dictate, and may not reflect the opinions of other investment teams within William Blair Investment Management, LLC or the Investment Management Division of William Blair & Company, L.L.C.

This content is for informational and educational purposes only and not intended as investment advice or a recommendation to buy or sell any security. Investment advice and recommendations can be provided only after careful consideration of an investor’s objectives, guidelines, and restrictions.

Factual information has been taken from sources we believe to be reliable, but its accuracy, completeness or interpretation cannot be guaranteed. Investments are subject to market risk. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Statements concerning financial market trends are based on current market conditions, which will fluctuate.

William Blair does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax questions and concerns.

Distributed by William Blair & Company, L.L.C., member FINRA/SIPC.

Copyright © 2017 William Blair & Company, L.L.C. "William Blair” is a registered trademark of William Blair & Company, L.L.C. No part of this material may be reproduced in any form, or referred to in any other publication, without express written consent.

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Please carefully consider the Funds’ investment objective, risks, charges, and expenses before investing. This and other information is contained in the Funds’ prospectus, which you may obtain by calling +1 800 742 7272. Read it carefully before you invest or send money. Investing includes the risk of loss.

Any statements or opinions expressed are those of the author as of the date of publication, are subject to change without notice as economic and markets conditions dictate, and may not reflect the opinions of other investment teams within William Blair Investment Management, LLC or the Investment Management Division of William Blair & Company, L.L.C.

This content is for informational and educational purposes only and not intended as investment advice or a recommendation to buy or sell any security. Investment advice and recommendations can be provided only after careful consideration of an investor’s objectives, guidelines, and restrictions.

Factual information has been taken from sources we believe to be reliable, but its accuracy, completeness or interpretation cannot be guaranteed. Investments are subject to market risk. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Statements concerning financial market trends are based on current market conditions, which will fluctuate.

William Blair does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax questions and concerns.

Distributed by William Blair & Company, L.L.C., member FINRA/SIPC.

Copyright © 2017 William Blair & Company, L.L.C. "William Blair” is a registered trademark of William Blair & Company, L.L.C. No part of this material may be reproduced in any form, or referred to in any other publication, without express written consent.

Statement of Financial Condition | NMS Rule 605 & 606 | Business Continuity Plan | UK Stewardship Code
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