Agency MBS Taper: Throw out the QE3 playbook
Background: To no one’s surprise, yesterday the Fed announced that they will begin to curtail their purchases of Treasuries and Agency MBS starting in mid-November. Since March 2020, the Fed has been net buying $120bn per month ($80bn UST, $40bn MBS), but going forward we’ll see a $15bn pro-rata reduction each month. At the proposed pace, the Fed is likely to halt net purchases in June 2022 or 28 months after embarking on QE4.
This isn’t 2013: For mortgage investors, the word ‘taper’ is typically followed by ‘tantrum’ as the 2013 QE3 experience was associated with sharply higher interest rates, a spike in interest rate volatility and wider Agency MBS spreads. While “this time it’s different” are too often famous last words, there are much different forces in the market today compared to 2013, leading us to believe that we could see a ‘taper’ without the ‘tantrum’, at least in the short to medium term:
- Transparency: The Fed’s decision to remove accommodation and taper in 2013 caught investors off guard, which resulted in a pull forward of projected rate hikes, a spike in interest rate volatility and wider MBS spreads.
- Holders of MBS: Entering the 2013 taper tantrum, ~40% of outstanding MBS was owned by relative value oriented investors – money managers, REITs, overseas investors. Fast forwarding to today, relative value investors have been reduced to holding ~20% of outstanding MBS, leaving banks and the Fed with a dominant market share of ~80%. This shift results in an active investor base that is underweight or under allocated to the asset class.
- Remaining purchases: The Fed is still expected to purchase $140bn net and almost $1 trillion gross Agency MBS through the end of 2022 as they maintain the size of their balance sheet.
- Fed to sell MBS: This was a risk in 2013, but less likely today as the Fed has expressed desire to maintain a larger balance sheet.
Outlook: Putting this all together, we believe Agency MBS investors seeking to navigate tapering may be better suited to leave the proverbial dust on their QE3 playbook - or throw it out entirely. Absent an uptick in interest rate volatility, we believe the Fed’s transparency around tapering and stronger technical backdrop may help keep Agency MBS spreads near historically tight levels (-10 OAS, 45 z-spread*) over the near term. However, as we move beyond the first half of 2022, spreads are likely to gradually converge toward longer term averages (10-20 bps wider in OAS) as technical factors soften and relative value investors begin to drive price action.