The extension of 2022’s burgeoning rates selloff in the wake of the December Fed minutes Wednesday wasn’t attributable to any assumptions among market participants about a resilient economy or confidence in the notion that the world can now “live with” tighter policy and COVID.
In contrast to the first two trading days of the new year, further rate rise on the heels of the hawkish color from the minutes “was outright risk-premium being added back into real rates,” Nomura’s Charlie McElligott said Thursday, describing a “multi-front FOMC attack on easy financial conditions.”
Real yields are the story of 2022 thus far. Note that we’re already approaching what I’d call the “danger zone” vis-à-vis the rapidity of the rise in reals (figure below is updated to include 2022’s burgeoning tantrum).
On Thursday morning, McElligott aptly described the Fed’s inflation problem as a “bipartisan” issue that leaves them “effectively boxed in.”
Nomura now sees four rate hikes in 2022 and possibly even five if inflation doesn’t slow down.
But the crucial nuance comes when you consider the passages from the December minutes which suggested some officials favor a swifter rundown of MBS versus Treasurys.
For example, one such excerpt said “some participants favored reinvesting principal from agency MBS into Treasury securities relatively soon or letting agency MBS run off the balance sheet faster than Treasury securities.”
This debate is long-running. It’s obvious MBS purchases were fuel on the fire for America’s new housing bubble (figure on the left, below), and the pandemic-era surge in property prices is now starting to find its way into “official” inflation on the usual lag (figure on the right).
What would it mean for risk assets if the Fed does opt to be more aggressive when it comes to trimming MBS holdings?
Spoiler alert: Nothing good, if past is precedent.
“When one looks at Nomura’s original analysis of the impact from Fed balance sheet unwind upon cross-asset markets from the last QT… the eye-opening ‘hard data’ takeaway was that when there is a MBS or MBS/UST QT-unwind week, those periods on average see larger moves, in particular to the downside for broader risk assets,” McElligott remarked. The figure (below, from Nomura) is from the bank’s work on QT’s previous iteration.
Why might that be the case? Well, it’s pretty simple really. MBS aren’t Treasurys. They’re spread product. So, when a price insensitive buyer begins to step away, the contagion channel to risk assets has the potential to be more “efficient” (the scare quotes denote that “efficient” is a polite euphemism in this context).
McElligott elaborated. “My finger-in-the-air theory is that MBS is a risk asset with a massively outsized portion of the market being held by the Fed, and when we widen there, it can negatively impact… other spread products, reverberat[e] into the collateral chain [and] spill over into the cost of capital and leverage.”
And there you have it. If you’re looking for things that could go wrong during the Fed’s latest attempt at balance sheet normalization, that’s as good a place to start as any.
Note that the Fed’s nods to paring MBS faster are well-intentioned. How many pundits have you heard over the past six months arguing (or even demanding) that the Fed cease MBS purchases immediately? Quite a few, if you’ve been listening.
Just know there may be consequences for any “unbalanced” approach to balance sheet runoff.
“[A] rubber-stamped balance sheet runoff path that may favor more aggressive [rundown] of MBS alongside simultaneous rate hiking is absolutely an escalation of risks to interest rates,” McElligott went on to say Thursday, in the course of suggesting “formerly placid easy financial conditions are set to inflect into something which risks ‘putting back’ vol into the market instead of previously ‘absorbing’ it.”
With apologies to Buffett, MBS would appear to be weapons of mass financial destruction with little redeeming social value. They were the root of the problem in 2008, are an outsized factor in our current inflationary moment, and have helped drive housing unaffordability to levels never seen before. My heart would love to see the Fed let them run off before its Treasury holdings, but (per McElligott) my head tells me that would hurt the average guy more than fat cats. Privatize the gains, socialize the losses — the more things change, the more they stay the same.
If you recall the 2008 housing bubble wasn’t a result of JUST MBS investments but also a mixture of misrated securities in the form of AAA tranche MBS’s that were full of low grade crap AND a huge investment in CDS (Credit Default Swap) hedges. The CDS’s are really what exacerbated the problem because not only did the MBS’s stop paying but the MBS holders had to pay out to the CDS holders which caused a gigantic selloff in all of those securities to get out from under them.
I disagree that MBS provide “little redeeming social value”. While they are exacerbated in bubble finance, without them there would be almost no path for the average American to get to home ownership. Unless you’d like to go back to the days of 15% interest rates and 25% down payments on homes. That really boosted the economy in the 80’s…
I dunno. Seven percent mortgage rates and 20 percent down seemed to work quite well before the advent of MBS.
Remember there are several kinds of MBS securities, the two main ones being “agency” backed or created, and privately created and issued securities (see the “Big Short”). There are also Ginnie Mae pass-throughs, for example, which I have been buying for 40 years or so. When I started buying those rates were high and the returns were great. There was no “insurance” for early mortgage-based securities. Before the rise of CDSs some of the insurers serving the muni-bond market started dabbling in insurance for MBSs, a strategy that didn’t end well, for some at least.
Not only are MBS spread products, but they are also explicitly negative convexity instruments (due to the embedded prepayment options that the holder is short). A faster unwind of MBS is basically adding rate vol risk back to private sector balance sheets, which should raise credit risk premiums more broadly (in theory anyway).
H-Man, call it what you want, rates are rising.
Reducing MBS is equivalent to the Fed buying volatility, which is a huge change since they have been selling it for so long. As MBS returns to private hands convexity risk needs to be hedged, which means demand for rate vol, which by the way we are already seeing how the MOVE / VIX spread is moving. The second thought from reading this article was that the Fed is realising that in order for any of their actions to prove effective they need to see a visible tightening of financial conditions which when the SEP forecasts were revealed it was not really obvious that there forecast where signalling that. They had the unemployment rate below NAIRU, with inflation normalising fairly quickly, with the real policy rate negative throughout the horizon period. I like to say that this was internally inconsistent. But if you combine that with faster balance sheet reduction, which they are now signalling and a shock to markets who based on the Primary Dealer Survey saw this has a Q3 2023 idea, then you have a major policy change which the markets are now grabbling with. Some participants in the Minutes seem to like faster balance sheet reduction as a factor than mitigates against curve flattening, which only heightens the risk of a recession signal from the market. That logic is somewhat twisted for sure, but one can sort of get where they are coming from. Tighten faster but make sure curve is steeper so markets don’t freak out about how you are tightening.