The Fed Should Get Out of the Mortgage Market

If the Federal Reserve is truly as outcome-based as it claims to be under its new policy framework, it should start winding down its purchases of mortgage-backed securities. The fact that it’s not even thinking about doing so is revealing about just how hesitant it is to make even the slightest tweaks to monetary policy at this point in the economic recovery.

Lost in the shuffle last week amid all the Fedspeak about inflation and Friday’s shocking jobs report were comments from Boston Fed President Eric Rosengren. “My own personal view is that the mortgage market probably doesn’t need as much support now. And in fact, one of my financial stability concerns would be if the housing market gets too overheated,” he said. “I do think that as we think about tapering one of the things that we are going to have to think about is at what speed we taper the Treasuries versus the mortgage-backed securities.”

While Rosengren also added to the central bank consensus that it remains premature to focus on tapering, a view only reinforced by the U.S. labor market adding surprisingly few workers last month, he raises an interesting question: Why exactly is the Fed still increasing its holdings of mortgage-backed securities by $40 billion a month when Chair Jerome Powell himself has said that “the housing sector has more than fully recovered from the downturn” and that the rapid price appreciation means “it just is going to be that much harder for people to get that first house.” Couldn’t the Fed be using its bond-buying bazooka more effectively?

It certainly seems that way, especially when gauging sentiment within the agency mortgage-bond market itself. “Outside of the central bank today, there was little impetus to buy,” my Bloomberg News colleague Christopher Maloney noted. Banks “mostly joined other investors on the sidelines, waiting for wider spreads.” The option-adjusted spread on the Bloomberg Barclays U.S. MBS index fell to just 0.07% at the end of April, the narrowest since 2010. It’s no secret why: The Fed has gobbled up almost $2 trillion of MBS since March 2020, which is more than its total aggregate purchases in any of its previous quantitative easing episodes.

The Fed Should Get Out of the Mortgage Market

As I mentioned on Twitter during Powell’s press conference in April, the Fed doesn’t have a satisfactory answer for why it’s throwing billions of dollars at mortgage bonds at this point. His answer boiled down to three things: First, that the MBS market was in chaos during the onset of the pandemic; second, that it bought them after the 2008 financial crisis so it should do so again; and third, MBS purchases are now inextricably linked to tapering in general, so it’s stuck buying them until it reaches the nebulous “substantial further progress” mark. Here’s Powell’s quote in full, which doesn’t even fully capture his struggle to answer: 

“Yeah. I mean, we started buying MBS because the mortgage-backed security market was really experiencing severe dysfunction, and we've sort of articulated, you know, what our exit path is from that. It's not meant to provide direct assistance to the housing market. That was never the intent. It was really just to keep that as, it's a very close relation to the Treasury market, and a very important market on its own. And so, that's why we bought as we did during the global financial crisis. We bought MBS, too. Again, not intention to send help to the housing market, which was really not a problem this time at all. So, and, you know, it's a situation where we will taper asset purchases when the time comes to do that, and those purchases will come to zero over time. And that time is not yet.”

This is the point where it’s important to differentiate between what the Fed should do and what the Fed will do. Every indication is that the central bank won’t touch its MBS buying until it starts a complete tapering, at which point investors like Bob Michele, global head of fixed-income at JPMorgan Asset Management, see the Fed cutting its purchases of U.S. Treasuries by $10 billion a month and MBS by $5 billion. If that starts in January 2022 as Michele suggests, that means the Fed will still have its hands in the mortgage market more than a year from now. That will probably happen, even though it feels unnecessary.

The Fed Should Get Out of the Mortgage Market

What should the Fed do? Easy: It could simply put its $120 billion of monthly bond buying to better use by shifting from MBS to long-term Treasuries until it reaches “substantial further progress.” This is effectively what Bank of America Corp. strategists argued for almost two months ago in what they dubbed “Operation Switch.” They said “the MBS market is showing increasing signs the Fed may be too large,” citing “a growing list of market dysfunction.” They urged policy makers to consider that “a ‘switch’ is not a ‘taper,’ rather it shows the Fed willing to address market dysfunction and establishes a longer runway to its end goals.” Another option, which Rosengren seemed to allude to, would be communicating that when it tapers, it will aggressively wind down the MBS side first.

Of course, the Fed hardly pretends to be so nimble. “Quantitative easing is an inexact science, and what we’re doing right now is supporting certainly the housing market, supporting financial markets generally, keeping the yield curve lower, keeping the 10-year down,” Minneapolis Fed President Neel Kashkari said Friday on Bloomberg TV. “Could somebody argue instead of being 120, is should be 110? Sure, we can have that debate. But it’s an inexact science.”

As long as U.S. housing prices increase year-over-year by more than 10%, as they have for each of the past three months, Fed officials should continue to face questions about the central bank’s presence in the mortgage market. After all, no one is asking for them to do this. Would-be MBS buyers are sitting out, waiting for spreads to widen, suggesting the MBS market would function just fine without central-bank meddling. Look no further than corporate bonds, where investors are all too eager to buy debt from companies with deeply speculative-grade ratings, for proof that there’s no shortage of demand for debt with a bit of extra yield. That includes appetite from banks that are flush with extra reserves specifically because of the Fed’s balance-sheet expansion.

In the end, the Fed seems content to be like the unwanted guest at a house party who just won’t leave. No one is going to kick the central bankers out, but it might be nice if they gave some indication that they’re exiting soon.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

©2021 Bloomberg L.P.

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