Will the Mortgage Whale Torpedo the Market Rally?

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1 MAY Will the Mortgage Whale Torpedo the Market Rally? Tracy Chen, CFA, CAIA» The Federal Reserve (Fed) has telegraphed its intention to start tapering its balance sheet, causing investors to evaluate what could happen to asset prices in markets where the Fed is a significant bondholder. In light of the 2013 taper tantrum, we think the Fed will taper slowly and cautiously. The Fed's original message was that normalizing its balance sheet would commence after tightening was on schedule and well under way. The market interpreted this timing to mean when the fed funds rate was close to 2%, meaning probably not until the second half of What will be more difficult to understand is how markets will respond once one of their primary buyers tapers its purchases. For example, Treasury yields actually rose after rounds one and two of quantitative easing (QE). What about mortgage-backed securities (MBS)? This is a market that counts the Fed as an even bigger investor than Treasuries as shown in Chart 1, and which is why I think we need to pay more attention to how tapering purchases could affect the U.S. MBS market. It makes sense that an increase in MBS supply induced by Fed tapering should put upward pressure on spreads. Given the Fed's significant MBS holdings, markets are growing concerned about whether the big mortgage whale could torpedo the risk rally. The Fed's recent meeting minutes may have hinted at fast-tracking normalization to the end of 2017, even though broad questions regarding monetary policy and fiscal stimulus remain to be answered. What will be the market impact of tapering government MBS reinvestments? The market will of course need to adjust to the Fed's shrinking footprint in the MBS market and deal with increasing supply. More importantly, the market will have

2 to deal with higher prepayment risk and higher option costs, since the Fed has gulped down the most negatively convexed MBS portfolios with the worst prepayment features. I'll take a look at how the Fed could taper MBS purchases, how the decision could affect MBS reinvestment, and review past and current MBS spreads to provide an understanding of how the market could respond. How the Fed Could Taper MBS Purchases Let's take a closer look at the mechanics of tapering MBS reinvestment. On the asset side, the Fed's $4.21trillion balance sheet includes $2.45T of Treasury bonds, $1.74T of agency MBS, and some small amount of agency debt. On the liability side, the Fed holds $1.5T in currency, $2.4T excess reserves, with reverse repos and Treasury deposits making up the remaining $0.5T. The Fed has stated it does not expect to sell agency MBS as a part of the tapering, although in the long term it might consider selling a limited amount to reduce residual holdings. I think the Fed will be careful not to surprise the market in order to avoid triggering excessive volatility. Therefore, the central bank will likely communicate its intentions and tapering guidance in advance. However, there is a risk of policy discontinuity if we have a new Fed Chair after Yellen's term ends next year. There are uncertainties embedded in agency MBS pay down speed due to the prepayment option, which is driven by paths of interest rates, shifting in housing market dynamics, and credit availability. According to Fed Reserve data, the central bank's average reinvestment in MBS throughout 2016 amounts to $27.8B per month. The current 30-year Freddie Mac mortgage rate is 4%, 60 basis points (bps) higher than its trough in July 2016, which means half of the outstanding MBS are out of money to refinance. As shown in Chart 2, the coupon breakdown of the Fed's MBS portfolio is mostly concentrated between the 3-3.5% coupon. The current mortgage rate renders most of those prepayment options obsolete. Given the current higher mortgage rates and the MBS coupon breakdown, prepayment should slow down considerably over the next several years, probably to the degree of $10-$15B per month if the 10-year Treasury yield hovers around 2.5% and 3%. In addition, depending on what approaches the Fed takes to taper reinvestment either by a fixed percentage or a fixed dollar amount the effect will be different. In my opinion, a fixed percentage would not make sense as it is too pro-cyclical, and the Fed will reduce reinvestment faster when economic conditions worsen and rates rally.

3 Can the Past Inform the Future? Let's look at recent history to see how MBS spreads reacted to the Fed's intervention. Chart 3 outlines the MBS spread's trajectory as measured by the current coupon option-adjusted spread (OAS) to the London Interbank Offered Rate (LIBOR) over a timeline of major Fed events. We can see that MBS spreads widened by about 30bps in 2010 when the Fed first tapered its MBS reinvestments. When QE 3 was announced, MBS tightened by 70bps, only to reverse quickly. During the terribly managed rhetoric surrounding the future of tightening in 2013 and resulting taper tantrum, the MBS spread widened by 40bps and also reversed later. Surprisingly, when the Fed reduced its reinvestment in MBS from $80B a month to $30B a month in 2014, MBS spreads tightened rather than widen, due to the Fed's better market guidance. The Fed has been a major player in the MBS market after the global financial crisis. Therefore, the only historical period that we can look at to gauge the natural MBS basis without the Fed's intervention is the pre-crisis period. Chart 4 shows that the time period of as short as it is is probably the only good indicator of the natural status of the MBS basis.

4 So How Much Spread Widening Could We Expect? At the risk of over simplifying, there is probably room for MBS spreads to widen by about 15-20bps when the Fed actually does taper. However, it would be naïve to think this widening process will take place in a benign, peaceful, and gradual manner. It could well be violent in the short-term, and reverse later. But it is hard to foresee extreme volatility given the Fed's gradual and well-telegraphed approach. Of course, the MBS basis will also be driven by whether the Fed will taper both Treasury and MBS reinvestment, or just MBS only. Mitigating Factors to Spread Widening Organic MBS new supply in 2017 has been strong with $300B in new issuance, with foreign buyers as one of the largest net buyers. I don't view the $15-20B in additional supply due to the Fed's taper as excessive, or possessing the capability to crash the MBS market or permanently torpedo the risk rally, as I alluded to earlier. I think investors and foreign buyers will assess relative value and step in when spreads widen to a certain point. Some other relative value factors also should mitigate the MBS selloff and put a floor to it: First, tight investment grade corporate spreads should mitigate MBS basis widening. Second, the European Central Bank and Bank of Japan QE should also put a floor on MBS basis widening. Most importantly, higher rates and lower prepayments going forward should decrease the overall amount of monthly reinvestments needed to be absorbed by the market. Case in point is that agency MBS missed the rally year-to-date, because I believe this market has already priced in part of this tapering overhang. To illustrate this point, the spread between agency MBS versus investment grade credit gapped to its widest point year to date (Chart 5).

5 Will MBS spreads widen enough to spook investors? Given my analysis of previous and current spreads particularly when viewed in conjunction with major Fed decisions my answer is probably not. Overall, my view on U.S. MBS basis is neutral for now. Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach Brandywine Global Investment Management, LLC. All Rights Reserved. Social Media Guidelines Brandywine Global Investment Management, LLC ("Brandywine Global") is an investment adviser registered with the U.S. Securities and Exchange Commission ("SEC"). Brandywine Global may use Social Media sites to convey relevant information regarding portfolio manager insights, corporate information and other content. Any content published or views expressed by Brandywine Global on any Social Media platform are for informational purposes only and subject to change based on market and economic conditions as well as other factors. They are not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy. This information should not be considered a solicitation or an offer to provide any Brandywine Global service in any jurisdiction where it would be unlawful to do so under the laws of that jurisdiction. Additionally, any views expressed by Brandywine Global or its employees should not be construed as investment advice or a recommendation for any specific security or sector. Brandywine Global will monitor its Social Media pages and any third-party content or comments posted on its Social Media pages. Brandywine Global reserves the right to delete any comment or post that it, in its sole discretion, deems inappropriate or prevent from posting any person who posts inappropriate or offensive content. Any opinions expressed by persons submitting comments don't necessarily represent the views of Brandywine Global. Brandywine Global is not affiliated with any of the Social Media sites it uses and is, therefore, not responsible for the content, terms of use or privacy or security policies of such sites. You are advised to review such terms and policies.