Fed’s Retreat From Mortgages Approaching Tipping PointJody Shenn
The Federal Reserve is about to find out how well the mortgage-bond market can stand on its own.
Fed buying of the securities that helped spur a housing recovery is poised to fall below growth in the $5.5 trillion government-backed market as soon as May, Nomura Holdings Inc. said. Last year, the Fed added twice as much of the debt as was created, suppressing yields that guide mortgage interest rates.
The balance is shifting as the central bank steadily scales back its support of the U.S. economy at the same time home buying approaches its peak season. That creates a new challenge for a housing market that policy makers have been seeking to prop up since it crashed six years ago and threatens to inflate borrowing costs. Investors already are on edge over a Fed statement last week that fueled speculation it may raise short-term interest rates sooner than forecast.
“We’re within a few months of needing private demand to offset supply,” said Brad Scott, Bank of America Corp.’s New York-based head trader for a type of government-backed mortgage bond known as pass-through securities. “The hawkish statement from the Fed occurred at a precarious time for the asset class from a medium-term supply and demand perspective.”
A more-immediate test for the market comes next month, when issuance of the types of bonds the Fed is buying overtakes its purchases for the first time since November, according to Credit Suisse Group AG.
Even as the Fed took its first steps last year toward trimming its stimulus, its influence in the market grew when measured against the pace of issuance and outstanding bonds. That’s because the expected Fed pullback, which began in January, sparked higher rates and a slump in homeowner refinancing, which was followed by a seasonal slowdown in property sales. Loan volumes this quarter fell to the lowest since 1997, according to the Mortgage Bankers Association.
Rates on a typical 30-year mortgage rose to 4.4 percent this week from 3.31 percent in November 2012, though are still below a 20-year average of 6.26 percent and a 2013 high of 4.58 percent in August, Freddie Mac surveys show.
The increase is denting a recovery in the housing market, with sales of previously owned homes falling to a 4.6 million seasonally adjusted annual rate in February, the weakest since July 2012, according to the National Association of Realtors. The National Association of Home Builders/Wells Fargo index of builder confidence was 47 in March. Readings below 50 mean more survey respondents reported poor market conditions than good.
Borrowing costs remain low enough to support real estate, Fed Chair Janet Yellen said March 19 in her first news conference since assuming the role.
“There’s a lot of demographic potential there for new household formation that would ultimately generate new construction,” she said. The low rates “should serve as a stimulus to people coming back into the housing market.”
The central bank began adding $40 billion a month of mortgage bonds to its holdings in September 2012, a figure that will drop for a third time this year by $5 billion to $25 billion in April, according to a Fed statement before Yellen’s news conference. That’s in addition to purchases of Treasuries as well as reinvestment intended to prevent its holdings from shrinking.
While the Fed’s pullback isn’t “on a preset course,” policy makers said they’ll likely reduce purchases “in further measured steps at future meetings” if the economy matches expectations.
At the same time, monthly home-loan originations are set to average $95 billion from April through September, or $20 billion more than this quarter, according to Mortgage Bankers Association forecasts. Loans for home purchases will rise to $163 billion next quarter and then to $195 billion in the third quarter, from $115 billion.
Bank of the West, which grants home loans in 19 states, is already getting busier after a winter in which unusually cold weather probably exacerbated the typical seasonal slowdown, said Karen Mayfield, the mortgage-banking national sales manager at the San Francisco-based unit of BNP Paribas SA. The bank’s loan closings will rise about 30 percent in April from March, she said in a telephone interview.
“Now that we’re seeing some sunshine, our business has really started to pick up,” Mayfield said.
Loans used to purchase homes more often add to debt outstanding in the market than refinancings. Expanding volumes will about double the growth in agency mortgage bonds from recent months to more than $20 billion in each of May and June, Nomura analysts led by Ohmsatya Ravi wrote in a March 21 report. Last year, the Fed’s net purchases more than doubled net supply of $256 billion.
Agency mortgage bonds -- or those guaranteed by taxpayer-backed Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae -- have gained 1.7 percent this year through yesterday, the most in a quarter since 2011, underperforming similar-duration government debt by 18 basis points, according to Bank of America Merrill Lynch index data.
While a measure of relative yields on the debt widened 6 basis points from last year to 39 as of March 25, it remains less than the 2013 high of 68, the data show. A different metric used to track spreads in the most active part of the market is little changed at 121 basis points, or 1.21 percentage points, as of 10 a.m. today in New York, according to data compiled by Bloomberg. That is about 25 basis points below its 20-year average.
That spread between yields on agency mortgage bonds used to package new loans and an average of 5- and 10-year Treasury rates will need to increase about 24 basis points to attract private investors to absorb supply once the Fed ends its buying, the Nomura analysts wrote. That will start to happen with the coming mismatch in supply and central bank purchases, they said.
“When the Fed started buying mortgages in a really big way, we got out of the way,” said Matt Freund, chief investment officer of USAA Mutual Funds, who oversees more than $60 billion. The debt would need to reach “more of a market-clearing price” for his firm to consider buying again, he said.
The Fed’s sizable holdings and a better prepared market means there’s little chance that relative yields will widen as much as they did last year after the central bank began signaling its retreat, said Gary Kain, president of American Capital Agency Corp., the second-largest mortgage real-estate investment trust with $76 billion of assets.
William Irving, a fixed-income manager who helps oversee $2 trillion at Fidelity Investments, said Fed holdings that have expanded to $1.6 trillion also will exacerbate periods of spread tightening by reducing trading.
“There’s the potential that spreads need to move wider, but on the other hand given the size of the Fed’s footprint and the potential for volatility, I don’t think they’re rich enough to warrant” holding less than found in benchmark bond indexes, he said in a telephone interview.
Yellen’s estimate last week that the Fed may start increasing its short-term interest-rate benchmark “around six months” after its purchases end also fueled doubt on how long it will maintain the size of its holdings with its reinvestment program, according to Nomura and JPMorgan Chase & Co. analysts.
The Fed said in 2011 that the program would end before it starts raising its rate benchmark. If it were to stop immediately after the projected end of its new buying in October, “the impact on the market could be quite severe” because it would add about $100 billion of supply to the market over 6 months, JPMorgan analysts led by Matt Jozoff wrote.
The Fed’s settled purchases over the past four months equaled 106 percent of issuance of bonds traded in the main part of the market, according to Credit Suisse analysts led by Mahesh Swaminathan. Its $45.2 billion of purchases next month will equal 70 percent, with the share dropping to 46 percent by June.
The “potential tipping point” is a reason for caution, the analyst wrote in a March 20 report.
Even if not an immediate threat, the market is facing an end to longer-term demand fueled by the government, said Robert Bayston, a managing director at Bank of New York Mellon Corp.’s Standish unit. The Fed purchases followed a decade where prices were supported by Fannie Mae and Freddie Mac, which now are being forced to shrink their balance sheets, he said.
“The next several weeks probably won’t be a turning point but we are concerned over the next year or so,” said Bayston, who helps oversee about $160 billion of fixed-income assets. “Spreads are going to need to widen enough to attract capital that’s now being dedicated to other assets.”