The Fed recently announced its second rate hike for this year but also – and, perhaps, more importantly – outlined its preliminary plan for reducing its holdings in mortgage-backed securities (MBS) and Treasuries.
Currently, the Fed’s balance sheet stands at approximately $4.52 trillion, about $2.46 trillion of which are Treasuries and about $1.77 trillion of which are MBS. It acquired about $3.7 trillion of these assets in the years following the recession as part of its Troubled Asset Relief Program. The Fed plans to reduce its balance sheet gradually by not reinvesting in the bonds as they mature.
So what impact will this “quantitative tightening” have on the mortgage market? As many economists point out, shrinking the balance sheet is not that risky in and of itself; rather, it is how the process is managed that could cause market volatility. Just the simple fact that the Fed won’t be maintaining its large pile of assets will mean monetary conditions will tighten at a time when it is already raising interest rates.
During the past few years, when the Fed announced that it was slowing its purchases of assets, there was resulting volatility in the markets. This time around, the Fed’s monetary policy is many times more complex, as it will be strategizing how to shrink its balance sheet while also raising interest rates. This makes things more complex – and more uncertain – because it gives investors many more indicators to consider.
To find out more about how the Fed’s plan to shrink its balance sheet might impact the mortgage market, MortgageOrb recently interviewed Lindsey Piegza, chief economist at Stifel Fixed Income, and Frank Nothaft, senior vice president and chief economist at CoreLogic.
Q: How do you think the Fed’s plan to reduce its balance sheet might impact the mortgage market? What do you see as being possible risks or benefits of its plan?
Piegza: Obviously, on the surface, the plan is taking a consistently large buyer out of the marketplace, which one would instinctively presume would cause volatility. But the Fed intends to be completely transparent during this process in order to mitigate any adverse reaction from investors. Still, the market’s reaction, no matter how well the Fed communicates a plan, remains a wild card. Of course, the Fed has also been clear that, should the market appear unstable after reinvestment tapering begins, it remains willing and able to halt the process.
Nothaft: The Fed has chosen a gradual approach to reducing its agency debt and MBS portfolio. The reduction has not yet begun but is expected to be implemented later this year. The plan will reduce its holdings by a maximum of $4 billion per month over the first three months – a small decrement relative to its $1.77 trillion in holdings.
The effect on mortgage yields will likely be small as other investors enter the market to acquire MBS. Nonetheless, there can be upward pressure on MBS yields as a large purchaser (the Federal Reserve Bank of New York) reduces its acquisitions. Mitigating the effect is the fact that origination volume is expected to be down about 20% in 2017 compared with 2016 because higher mortgage rates have reduced refinance activity.
Q: On the flip side of that, what do you see as being the risks or benefits should the Fed keep those assets on its books for a while longer?
Piegza: Well, remember, the Fed is not talking about outright sales at this point; it is still focused on principal reinvestment or slowing the pace of additional purchases.
Nothaft: The risk is the mortgage market becomes dependent on the Fed rather than private capital, and it could hamper the Fed’s response if there is another mortgage finance crisis. The benefits are small but likely include slightly lower mortgage rates and a stable investor source (i.e., purchases by the Federal Reserve Bank of New York).
Q: Do you think the Fed can successfully keep markets stable and the economy on track while simultaneously raising rates and reducing its balance sheet? How difficult do you think this will be for the Federal Open Market Committee? Do you have confidence in its ability to do so?
Piegza: “On track”? I suppose it depends on what track you’re hoping to be on. I would argue a fragile economy barely eking out 2% growth is hardly a path to strive for. So if the Fed has been unable to get the economy back on track with years of unrelenting support, what evidence is it looking at to suggest the economy will continue to fare at even today’s moderate pace with less support, let alone increase the pace of activity beyond the moderate level of growth since the financial crisis?
At this point, the Fed appears to be raising rates against the backdrop of modest conditions simply because it realizes this may be as good as it gets and the committee wants to restock at least some tools in their monetary tool box to combat weakness (or an eventual recession) over the coming months/years.
Q: Anything else you want to add about the Fed’s plan to reduce its balance sheet or about the impact of additional potential rate hikes?
Nothaft: The steps the Fed has taken to increase the transparency of its actions have helped to lower volatility in the capital markets. A gradual approach has been important to lessening the likelihood of interest rate spikes.