How will the mortgage-backed securities market function now that the Federal Reserve has ended its program to buy more than $1 trillion in securities?
The world’s biggest bond fund, Newport Beach-based Pacific Investment Management Co., says investors will keep mortgage rates down.
Q: The Federal Reserve recently completed an unprecedented $1.25 trillion in purchases of Agency mortgage-backed securities. How will the program’s termination impact the market for MBS in the months ahead?
Simon: We are unlikely to see a significant market disruption in the Agency market stemming from the Fed’s retreat. First, the retreat had been well advertised for months before the event. Investors knew exactly when the program was going to end and how much the Fed was buying. So it’s not as if anybody woke up and was surprised by the fact that the Fed had stopped buying.
Second, private buyers are in a much better position today than they had been before the Fed started buying. The private balance sheet was seriously impaired by the financial crisis at the time the Fed stepped in with its public balance sheet. But by October 2009 or so, the private balance sheet had improved. The Fed probably could have stopped buying at that point with about $850 billion in completed purchases, but it felt compelled to reach the previously announced total of $1.25 trillion, and so the next $400 billion in MBS drove prices higher.
Q: How are private buyers approaching the MBS market now? And will yields jump and prices stumble with the Fed out of the game?
Simon: As mentioned, the final $400 billion or so of Fed purchases were pricey, and some private investors, including PIMCO, sold a portion of their holdings to the Fed. Thus 2010 began with many money managers underweight mortgages.
So if and when we see mortgages cheapen, we expect to see private institutions stepping in to buy. Even a 15 basis point move could spark a flurry of buying. Therefore, we don’t expect a major widening of mortgage spreads, unless Fannie Mae and Freddie Mac sell some of their holdings, which would be something of a game-changer.
Because we expect investors will continue to buy on the dips, we don’t believe the Fed’s retreat will have a substantial impact on mortgage rates charged to homebuyers. Clearly, broader changes in interest rates will impact mortgage rates, but the end of the Fed’s buying program probably won’t have a significant effect.
Q: Could you elaborate more on who will fill the purchasing gap left by the Fed’s exit?