Why The Agency Mortgage Market Has Been Struggling In 2018

by: Tortoise


Why we think supply and demand technicals will drive Agency MBS performance in 2019.

We expect supply will remain heavy in 2019 and the Fed portfolio run-off will add $200 billion to absorb.

The market may no longer be able to rely on Agency or Fed buying.

Valuations will need to widen further to bring supply and demand in balance.

By Senior Portfolio Manager Jeff Brothers

The agency mortgage market, one of the largest, most liquid fixed income sectors, has been struggling in 2018. Today, we wanted to take a closer look at the recent performance and share our outlook for the agency mortgage market.

The agency mortgage sector performed very poorly in October, under-performing U.S. Treasuries by 37 basis points. Despite the high quality and strong liquidity of the sector, the mortgage market turned in its worst monthly performance in two years. Yield spreads versus U.S. Treasuries moved 10 basis points wider in October to 85 basis points and are now at the widest levels since the middle of 2016. The recent under-performance can be attributed to the sharp rise in interest rates, higher volatility and a general market risk aversion. With improved valuations and mostly favorable fundamentals, we believe the key to the outlook going forward will depend on the uncertain supply and demand technicals.

Although modestly below 2017 levels, net mortgage supply remains very heavy, with expectations for $275 billion in 2018. With higher mortgage rates, a reduction in the home-ownership tax benefit, and rising home prices, the overall housing market has started to slow. With a slower pace of new and existing home sales, we would expect a modest decline in supply for 2019. Unfortunately, despite the moderation in supply, the market will also have to contend with the mortgage supply running off the Federal Reserve’s balance sheet. The Fed accumulated $1.8 trillion in agency MBS through the quantitative easing program in support of the housing market and now the tide is rolling back out. Given the current level of mortgage rates, we would expect an additional $200 billion in supply to run-off the Fed’s balance sheet in 2019. The Fed through outright purchases and reinvestment of principal has also been the most consistent buyer of mortgages since the QE program started seven years ago. The Fed ended outright purchases in 2014 and steadily reduced the amount of mortgage reinvestment each quarter since the end of 2017. With the monthly cap on mortgage run-off moving to $20 billion in October, and monthly mortgage pay downs expected to range between $15 and $18 billion going forward, we may have seen the last of the Fed’s reinvestment buying. The mortgage market for the first time will now be operating without the safety net buying from Fannie Mae and Freddie Mac prior to the financial crisis or from the Federal Reserve post crisis.

We also expect challenges from the demand side of the mortgage market. Money managers and international buyers have done their part in absorbing the heavy supply with net additions year-to-date of $140 and $83 billion, respectively. Both, however, may face headwinds going into 2019. Money managers may find the current valuations attractive, but are already overweight the sector and international buyers face prohibitive hedging costs. Domestic banks were a significant buyer last year, but have failed to maintain the pace in 2018. Banks are expected to add only $60 billion in 2018 versus net purchases of $110 billion in 2017. A variety of reasons may keep bank purchases subdued, including strong loan growth, regulatory constraints and weak deposit growth.

Putting all the pieces together, we maintain our defensive outlook for the agency mortgage market. With the most recent selloff, mortgage valuations have improved and yields spreads are at the widest levels in over a year. The fundamentals are also mostly positive with low refinancing and extension risk offset by higher interest rate volatility. Unfortunately, the negative supply and demand technicals and the overhang from the Fed’s portfolio runoff will dominate the market. We do not expect another terrible month like October, but the market will probably need to cheapen up a little more to bring supply and demand back into balance.

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 article 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. Discussion or analysis of any specific company-related news or investment sectors are meant primarily as a result of recent newsworthy events surrounding those companies or by way of providing updates on certain sectors of the market. Tortoise, through its family of registered investment advisers, does provide investment advice to Tortoise related funds and others that includes investment into those sectors or companies discussed in these articles. As a result, Tortoise does stand to beneficially profit from any rise in value from many of the companies mentioned herein including companies within the investment sectors broadly discussed.

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