Mortgage bond investors are about to become reacquainted with ‘moral hazard’ and its inevitable consequences.
As the Federal Reserve continues to pull out of US Treasurys and mortgage bonds (the Fed entered its “peak” monthly unwind phase in Q4, where it will allow up to $30 billion and $20 billion in MBS to roll off and on Oct. 31 its balance sheet declined by more than $33 billion, the largest one-week drop since the start of QE), holders of housing bonds who had grown accustomed to steady returns in a rigged market endured their biggest shellacking in 2 years, as Bloomberg pointed out in a story published Friday.
And while at least one prominent bond investor pointed out that Bloomberg’s warnings about a “bloodbath” in MBS may have been exaggerated…
Ridiculous BBerg News story today on the (non-existent) “bloodbath” in the mortgage-bond market in Oct. MBS Index Return: -.6%. LQD: -2.1%.
— Jeffrey Gundlach (@TruthGundlach) November 2, 2018
…the story’s central premise that the retreat of the bond market’s ‘marginal buyer’ is creating headaches for complacent bond bulls is certainly valid, as we’ve said before. It only takes a quick glance at the 10-year-yield vs. the Fed’s balance sheet expansion/unwind to spot the dangers that could lie ahead.
Now, as the Fed-generated tidal wave of liquidity slows to a trickle and the central bank looks to unwind some $1.7 trillion in MBS holdings, “savvy” bond bulls are stuck asking themselves: who the hell is going to step in and stop the bleeding once liquidity dries up further and mortgage bonds continue to fall?
The answer isn’t immediately clear.
Kevin Jackson, a managing director on Wells Fargo’s mortgage trading desk recently told Bloomberg:
“When the Fed announced they were going to buy mortgages, we tightened a lot and rolls performed really well – now the reverse is happening. One should expect widening.”
Indeed, last month, MBS returns lagged Treasurys by the widest margin since November 2016, when rates surged after Donald Trump’s surprise election victory.
And, as BBG reminds us, by pulling out of the market, the Fed is leaving investors to grapple with a scenario that hasn’t existed for 4 decades. For the first time since then, there will not be any government entity, including Fannie Mae and Freddie Mac, to help provide liquidity for mortgage backed securities. The market is going to be completely on its own, and this is coming at a time when rates are rising, which will likely slow down buyers and push spreads wider/
Investors, scrambling to look for help somewhere, are reportedly hoping that banks and money managers can help fill the role that the Fed is leaving from. However, there are quirky little challenges (such as the demand not actually existing) for banks and money managers to take on the task.
Ankur Mehta, the head of MBS research at Citigroup Inc., put the problem in clearer terms: “It is not obvious to us where that incremental demand for mortgages comes from. Domestic banks already earn an attractive return on reserves, while money managers are facing headwinds due to outflows and their existing MBS overweights.”
In a sign of just how much these bonds could fall, this is happening at a time when mortgages “are still looking rich” according to Mehta. He noted this in comparison to levels and spreads prior to the 2008 crisis, when the Fed was not in the market. The Fannie Mae 30 year current coupon spread over a blend of 5 year and 10 year treasuries ended October at its widest points since June 2017.
Of course, this outcome has been very thoroughly telegraphed. And we all know that this “solution” will only lead to larger problems, as it forces our economy to swallow this bitter medicine. If there’s a silver lining to be found, it’s that, if the Fed’s recent track record is any indication, they’ll be back in the market soon enough, blowing an even bigger bubble that future generations of Fed chairmen will need to grapple with.
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