Agency Mortgage Securities More Attractive As The Fed Pares Down Position

by: Tortoise

Summary

Balance sheet is expected to move the needle for the agency mortgage securities sector.

Good news for the mortgage market.

We believe the calm of today’s market could turn more turbulent as we head into 2018.

The much anticipated Fed announcement to normalize their balance sheet is expected to move the needle for the agency mortgage securities sector. The Fed plans to begin in October with a monthly reduction of $6 billion in U.S. Treasuries and $4 billion in agency mortgages. Through multiple quantitative easing plans, the Fed currently holds $1.7 trillion in agency mortgage securities, almost a third of the overall market. Going forward, they will allow their mortgage portfolio to gradually decline as principal on the mortgages is paid down or refinanced. The initial $4 billion monthly reduction will grow quarterly by $4 billion to a final cap of $20 billion per month.

Picking Up Speed

With the Fed laying the groundwork for months prior to the announcement, the actual news turned out to be a complete non-event. For all the concerns over another “taper tantrum," the agency mortgage market has actually been on a roll leading up the announcement and continued to improve following the news. The good news for the mortgage market is the reduction will start with a very modest amount and at the same time other buyers have recently stepped up purchases to offset the upcoming Fed supply. Both domestic banks and overseas investors have added mortgages to their portfolios with almost $100 billion in net purchases in the first half of 2017. Money managers have also recently been adding to MBS as mortgages have started to look attractive relative to competing asset classes such as investment grade credit. The net result is that the lead into balance sheet normalization turned out to be a great month for agency MBS with the sector, outperforming U.S. Treasuries by 35 basis points in September.

Buckle Up, Turbulence Expected

So far, so good for the mortgage market and the Federal Reserve, but again to borrow from Yogi Berra, “The future ain’t what it used to be.” We believe the calm of today’s market could turn more turbulent as we head into 2018. First, the modest monthly portfolio runoff turn more daunting by the 1Q of 2018 with $12 billion and by 3Q up to $20 billion by the third quarter. Secondly, the valuations for agency MBS are very rich from a historical perspective, driven in large part by the Fed’s dominate market position. Agency mortgages have averaged a yield spread over U.S. Treasuries of 75 basis point over the past four years compared to an average spread of 115 basis points? in the period prior to the financial crisis and prior to the Fed purchasing agency MBS. At a current yield spread of only 64 basis points, the lowest level in four years, the market valuation doesn’t provide much room for error. A lot can change in the supply and demand equilibrium between now and the first quarter of next year, but our view is that current, rich valuations will have to cheapen to attract new buyers to absorb the future Fed portfolio runoff.

Disclaimer: Nothing contained in this communication constitutes tax, legal, or investment advice. Investors must consult their tax advisor or legal counsel for advice and information concerning their particular situation. This article contains certain statements that may include “forward-looking statements.” All statements, other than statements of historical fact, included herein are “forward-looking statements.” Although Tortoise believes that the expectations reflected in these forward-looking statements are reasonable, they do involve assumptions, risks and uncertainties, and these expectations may prove to be incorrect. Actual events could differ materially from those anticipated in these forward-looking statements as a result of a variety of factors. You should not place undue reliance on these forward-looking statements. This podcast reflects our views and opinions as of the date herein, which are subject to change at any time based on market and other conditions. We disclaim any responsibility to update these views. These views should not be relied on as investment advice or an indication of trading intention.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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