Why the Refinancing Slowdown Matters for the Fed

logo-cropped-11The Fed is expected to slow down their purchase of agency mortgage-backed securities thanks to the refinancing slowdown

Source: The Wall Street Journal

The Federal Reserve has been buying up fewer mortgage bonds in recent months thanks to a flameout of the American refinancing boom, one factor that economists say is likely to help shape Fed officials’ thinking as they consider shrinking their giant bond portfolio.

The Fed expects to buy $18 billion of agency mortgage-backed securities in the month ending next Wednesday. That is less than half the amount it bought in the month ended right after the presidential election, according to data from the Federal Reserve Bank of New York, and the smallest purchase since mid-2014.

Because the Fed is buying up less of the mortgage bonds currently in the market, in many ways monetary policy is already tightening on its own, some traders and analysts say. They add that the Fed could view it as a step toward shrinking its $4.5 trillion balance sheet, as it considers whether to begin selling some securities later in 2017 after years of stimulative bond buying.

At their policy meeting in March, Fed officials agreed that they would probably start shrinking their portfolio later in the year but didn’t decide on key details of how to do it, minutes released Wednesday show.

The Wall Street Journal reported Friday that the Fed is formulating a strategy to start winding down its portfolio by slowing or stopping reinvestments of maturing debt, perhaps after raising short-term interest rates two more times this year. The minutes of the Fed’s latest meeting, due out Wednesday, may provide more clues about the central bank’s latest thinking.

The Fed’s holdings of agency MBS is likely to be a key area of consideration, given that the Fed holds nearly $1.8 trillion of the debt, or more than 40% of its holdings of securities scooped up through its open market purchase program, New York Fed data show.

Such securities are made up of pools of mortgages, and are backed by payments on those home loans. They are issued by government-sponsored enterprises such as Fannie Mae or Freddie Mac, and are seen by many investors as high-grade fixed-income instruments due partly to the notion of an implicit government guarantee, which reduces the risk.

Now, the pace at which those bonds are maturing is being slowed down by the drop-off in refinancing.

Last summer, around the time benchmark interest rates hit record lows, J. Edgar Mihelic, a 35-year-old accountant at a nonprofit, considered refinancing the 30-year mortgage on his Cape Cod-style brick home in Brookfield, Ill.

But he didn’t move fast enough. Following the U.S. presidential election, mortgage rates jumped as investors bet on faster economic growth and higher inflation once Donald Trump took office. An average fixed-rate 30-year mortgage came with an annual interest rate of about 4.3% this week, versus 3.5% about a month before the election, according to Bankrate.com.

“I waited around too long,” Mr. Mihelic said. Though he had thought about getting a new 15-year mortgage to replace his current one, he stuck with his current mortgage, taken out in the spring of 2013 with an annual interest rate of 3.65%.

Refinances are expected to have made up 41% of total mortgage originations in the first three months of the year, down from 51% in the fourth quarter of 2016, according to the Mortgage Bankers Association. That share is forecast to drop to 28% in the second quarter and 26% in the third.

When refinancing slows down, so does the rate at which mortgage bonds mature, because less mortgage principal is flowing directly back to bondholders in the form of so-called prepayments. That is already hitting the Fed’s portfolio of mortgage bonds, where the one-month annualized rate of paydown on the portfolio slowed to 15% at the end of February, down from 28% at the end of July, according to an analysis by FTN Financial.

The Fed in turn has less maturing bonds to reinvest. Many economists and investors say the Fed’s purchase of bonds is what eases financing conditions, and slowing those purchases can signal to markets that it intends to tighten policy.

To be sure, some argue that the act of holding debt on its balance sheet is a stronger easing measure — and slowing reinvestments doesn’t necessarily affect the size of the balance sheet.

But many analysts agree the purchases play an important role in how markets react. Bond yields shot up, for example, when the Fed signaled in 2013 that it could slow the pace of its quantitative easing program.

The slowing pace of purchases are already impacting the market, traders say. One measure showed the yield premium on a benchmark MBS security relative to the 10-year Treasury note reached 0.77 percentage point last week, up from 0.66 percentage point at the end of 2016, according to Michael Lorizio, senior trader at Manulife Asset Management. Some add there could be more pressure on the market.

“It is likely that we will see some spread widening in MBS bonds if we continue to see strong MBS issuance and slow prepayment speeds from the Fed’s MBS portfolio,” said Andrew Pace, a vice president at Performance Trust Capital Partners LLC, a fixed-income trading firm, in an email.

Still, bond traders say a big selloff is likely to attract fresh buyers which in turn could keep a lid on how wide the yield premiums rise. And the current impact of slowing prepayments could mean there is less of an impact later on when reinvestments stop.

“The last thing the Fed wants to do is to disrupt the mortgage market,” and create a negative feedback loop into the broader economy, said James Sarni, managing principal at Payden & Rygel Investment Management.