The main headline from the bond market this week was the Federal Reserve raising interest rates 50 basis points, as expected, and announcing it will begin allowing its holdings of Treasuries and mortgage-backed securities (MBS) to decline in June. The initial combined monthly pace will be $47.5 billion, stepping up over three months to a monthly total of $95 billion: $35 billion of MBS and $60 billion of Treasuries.
The question now becomes whether the central bank will engage in active MBS sales to reach its $35 billion roll off cap. Neither the statement nor the balance sheet plan repeated the goal of returning the nearly $9 trillion balance sheet, $2.73 trillion of which is agency MBS, to all Treasuries. There was no mention about the potential for active MBS sales, so it appears unlikely. Talk of active MBS sales had increased volatility in the MBS market recently.
MBS roll off is expected to drop to around $25 billion per month by July, and by the time the $35 billion maximum cap is instituted in September, the Fed’s portfolio roll off will likely be well below that level, as the overwhelming majority of American homeowners have no incentive to refinance with current 30-year lending rates around 5.5%. Even still, roll off should add more than $150 billion in additional supply through year end that private investors need to take down.
Letting some of these assets run off isn’t necessarily as easy as it sounds. The last time the Fed tried to shrink its balance sheet, it caused havoc in the repo market. Hedge funds that were looking to exploit minute mispricings in the Treasury market borrowed heavily to fund basis trades, but the stability of the financial system was threatened when repo rates – the hedge funds cost of borrowing – spiked. The Fed ended up extending emergency loans and ended balance sheet reduction.
This iteration of the Fed has been highly dovish for over 10 years, and though “the Committee is prepared to adjust any of the details of its approach to reducing the size of the balance sheet in light of economic and financial developments,” it’s hard for a leopard to change its spots. Over those past 10 years, the combination of low mortgage rates and a relatively flat yield curve has allowed mortgage lenders to enjoy low TBA roll costs. The recent rapid rise in mortgage rates have caused the new market coupons to have substantially higher roll costs.
As we’ve moved to higher coupons, we have substantially higher rolls (~44 basis points per month). This increases the typically assumed hedge cost of 1 basis point per day to around 1.7 basis points per day. TBA spreads have been extraordinarily wide for the past couple of weeks, with some coupons experiencing a half point bid / ask spread. Bid-offer spreads have widened to 8-10 basis points for low market coupons and go higher as you move up in coupon.
When hedging to match expiration, this means extensions that cause a roll are exposed to both the higher costs and the wider bid offer spread. The prevailing notion of extensions as a profit center in recent years has been reversed. MCT recommends taking a hard look at your extension policies and ensuring fees cover increased costs. Consider the liquidity of your production down the road based on expiration, and leverage AOT delivery where possible to avoid wide bid-offer spreads.