The FOMC yesterday reaffirmed their stance that the economic recovery would be a long slow process with weakness focused in housing, the banking sector, and the labor market.
Here are a couple key comments from the policy statement:
- "the pace of recovery in output and employment has slowed in recent months"
- "employers remain reluctant to add to payrolls"
- "Housing starts remain at a depressed level."
- "Bank lending has continued to contract"
- "the pace of economic recovery is likely to be more modest in the near term than had been anticipated"
Of course this isn't exactly a shocking revelation to anyone who's been watching the market, reading the news, or listening to talking heads go on and on about deflation and a double dip. The Fed did however feel this situation was serious enough to address it with a modest (very modest) shift in policy strategy.
From the FOMC Statement:
"To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature."
Plain and Simple: The Fed is not ready to totally back out of the market yet! To remain a supportive influence, the Fed will reinvest the cash that is generated when loans in their MBS and Agency Debt portfolio are paid off. The goal of reinvestments is to keep constant the face value of domestic securities held in the Federal Reserve’s System Open Market Account (SOMA).
Specific details of this operation have yet to be fully disclosed, this is what we do know...
The Desk will concentrate purchases in the 2- to 10-year sectors of the nominal Treasury curve, although purchases will occur across the nominal Treasury and TIPS yield curves. The Desk will refrain from purchasing securities:
- trading with heightened scarcity value in the repo market for specific collateral,
- maturing within five weeks,
- that are cheapest to deliver into the front-month Treasury futures contracts, and
- that the SOMA already holds in an amount that is, or is very near, 35 percent of the outstanding supply.
Plain and Simple: The "de minimis" manner in which they will conduct their operations suggests the Fed is serving up some lip service to address fears of a double-dip. View it as the Fed finding a way to tell the market "WE ARE STILL HERE, WE ARE NOT GOING TO LET CONTAGION SPREAD". If they had implemented something more drastic, the effect may have actually spooked the market into thinking it might be "crowded out" eventually.
How much will the Desk purchase each month in Treasury securities and how will this be communicated?
On or around the eighth business day of each month, the Desk will publish an anticipated amount of purchases expected to take place between the middle of the current month and the middle of the following month. This amount will be approximately equal to the amount of principal payments from agency debt and agency MBS expected to be received over that period, adjusted for any variations from prior periods.
Plain and Simple: the size of the desk's TSY purchases depends on how fast the Fed's MBS portfolio (and Agency debt) pays off.
I called attention to the terms "anticipated" and "expected" for a reason. TBA MBS trade forward by one month and settle once a month. Because of this the value (price) of front month delivery MBS coupon is based on the prepayment assumptions of the trading desk (as well as supply/demand). I am not sure what model Wellington uses but prepay speeds have been slow across the stack for the past year, yet the street continues to trade mortgages forward as if prepay speeds have not slowed by capacity contraints, a lack of home equity, and a major mismatch between the credit supplied by borrowers and the credit demanded by lenders.
With that in mind I am wondering what prepay model the desk will rely on for the determination (amount) of their TSY purchases. In my opinion this model should not be overly complicated. The mortgage loans in the Fed's portfolio are mostly 4.5s and 5.0s (4.0s third most bought). These loans are backed by borrowers who've already proven they can qualify and close in the current lending environment. Thus, their behavior is better modeled by a simple question: IS THEIR REFINANCE OPTION IN THE MONEY OR NOT?
Plain and Simple: There is a disconnect between the primary and secondary mortgage markets. The desk's assumptions should be based on where mortgage rates are priced, not where the current coupon is priced in the secondary market because the street is trading those bonds to extremely short durations.
The best part about this announcement: it dispels rumors that the Fed is gearing up to buy more agency MBS. This should make the market more efficient as it allows traders to price mortgages based on the timing of principal return and levels on the yield curve. It will be easier to tell if MBS are overvalued or undervalued.
In the end this is the most important message I hear coming out of the Federal Reserve: RATES WILL BE LOW FOR AN "EXTENDED PERIOD". How low can mortgage rates go? That depends on 3.5 MBS. Are 3.5s trading forward in size yet?
They are priced over par but most trading action is still in CMM and mortgage options. My best guess: the real money account base will have no choice but to trade 3.5s if they hit and hold 101-00. How much does this matter in the big picture though? As we've said time and time again, low mortgage rates are not the solution to the problems faced in the housing market. If mortgage rates do fall below 4.25%, the same borrowers who've refinanced in the past 20 months will be out looking for another one, this time at no-cost.
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