Mortgage Backed Securities: Tight Supplies, Tighter Spreads

On the tape (via Bloomberg):

Yields on Fannie Mae (FNM) and Freddie Mac (FRE) mortgage securities fell to the lowest relative to government notes in more than 17 years, as the Federal Reserve’s program to purchase $1.25 trillion of home-loan bonds bolsters the market.

The difference between yields on Washington-based Fannie Mae’s current-coupon 30-year fixed-rate mortgage bonds and 10- year Treasuries narrowed about 0.01 percentage point to 0.66 percentage point as of 10:31 a.m. in New York, the lowest since May 1992, the record low since at least 1984, according to data compiled by Bloomberg.

The spread has narrowed 0.09 percentage point since the Treasury’s Dec. 24 announcement of its expanded capital backstop and portfolio limits for government-supported Fannie Mae and Freddie Mac, as the Fed’s buying continues amid a decline in new supply reflecting lower home-loan applications. Demand by borrowers fell amid the Christmas and New Year’s holidays and as a rise in loan rates lessened refinancing.

My question is simple: What happens when the Fed stops buying $15 billion in agency MBS a week? Supply is tight, hence the spread compression. The agencies that have an unlimited backstop on are now allowed to increase their portfolios (remember they were supposed to shrink them before they were singularly a policy tool), at some point there will be supply aplenty.

Not very reassuring, is it?

Disclosure: No positions in MBS or the agencies