September 19, 2021

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Fed should ‘switch’ up its playbook and buy more Treasurys, fewer mortgage bonds, urge analysts

Federal Reserve observers want US Federal Reserve Chairman Jerome Powell to stay on his toes as the US steps up vaccination efforts and put an end to the COVID-19 pandemic in sight.

In particular, some analysts believe that Fed officials should consider adjusting their Fed about $ 120 billion a month Program to purchase assets in a manner that could pave the way for the smoother functioning of the market in key segments of the US debt markets.

This would not mean reducing monthly asset purchases. Rather, the policy change should better respond to a rising interest rate environment, especially if demand for new U.S. home loans cools after the pandemic helps heralds skyrocketing real estate prices and have low 30-year mortgage rates.

“As the Fed adjusts to an economy shortly before reopening (supported by a very strong fiscal tailwind), we expect that its accounting policy may become increasingly flexible,” wrote a team of BofA Global strategists led by Satish Mansukhani Research note.

“One option for the Fed is to convert some MBS purchases to UST,” the team wrote, referring to ongoing monthly purchases of central bank assets in government guaranteed form $ 7.3 trillion agency mortgage-backed securities market and that roughly $ 20 trillion US treasury market.

“The UST market believes the Fed’s footprint may not be big enough due to soaring UST supply and skittish investors with the rise in interest rates, while the MBS market is increasingly showing signs that the Fed may be too is great. “

The benchmark 10-year Treasury return

rose on Monday by almost 70 basis points year-on-year to 1.609% after reaching an annual high on Friday. The sudden spike in interest rates has put soaring stocks under pressure and fears of a possible spike in inflation as trillions of dollars in stimulus flood the financial markets.

The $ 13.8 billion Vanguard Morgage-Backed Securities ETF

According to FactSet, it was down 1.1% yoy on Monday. It tracks the reference index Bloomberg Barclays US MBS Float Adjusted Index.

While investors have turned their backs on growth stocks, they have drawn the tech-heavy Nasdaq Composite
+ 1.05%

In the large-cap area, which is defined as a 10% retreat from its most recent high, other large-cap benchmarks continue to push into the record area. The Dow Jones industrial average
+ 0.53%

scored his The fourth record in a row ends on Monday, during the S&P 500
+ 0.65%

saw a third record in a row.

Rising government bond yields have also raised concerns about a possible political misstep by the Fed, namely that it could reverse its easy-money policy sooner than expected, spooking investors and draining liquidity from the financial system.

The Federal Open Market Committee closed a two-day meeting on Wednesday, and while no material policy changes are expected, investors will be on the lookout for further clues to the central bank’s deliberations on its inflation expectations and rising bond yields.

Read:: Fed fed to remain cautious this week as Powell channels his inner Gary Cooper calm

At its most recent review, the Fed held nearly $ 4.9 trillion in US Treasuries and agency mortgage debt of $ 2.1 trillion as part of its record $ 7.6 trillion balance sheet.

The majority of all new US home loans taken out since the 2008 financial crisis have been written under higher credit standards than in the past. This allows the loans to be pooled and sold as bonds with government guarantees, while usually having an easy pickup from Treasurys for holders.

But problems have surfaced after the last few rounds of Fed asset purchases. The spread, or premium that investors earn on some government-backed mortgage bonds over benchmark treasuries, has fallen to negative levels. A negative spread on mortgage bonds can make treasury ownership a more attractive alternative, crowd out money managers, and hurt liquidity.

MBS option-adjusted spreads become negative

BofA Global

To counter this pressure and help restore market function, Mansukhani’s team said the Fed may want to consider gradually reducing its monthly mortgage bond purchases while pledging its net growth in mortgage assets from the current $ 40 billion to $ 20 billion reduce.

Scott Buchta, chief of annuity strategy at Brean Capital, said he agrees with the logic behind the Fed’s call for reduced purchases of mortgage bonds in the coming months, especially as mortgage loan volumes in the United States soar in the face of the surge interest rates begin to slow down.

The interest rate on 30 year fixed rate mortgages rose recently close to 3.05%This is a high that hasn’t been seen since July 2020 after it fell to a record low of around 2.65% in January, according to real estate giant Freddie Mac

“Fed MBS purchases will soon account for a much larger percentage of total production and we will soon be issuing a lot more government bonds that may / may require more Fed support,” Buchta told MarketWatch.

“If we advised the Fed, that would be one direction we would go.”