By Michael S. Derby
(Reuters) – Almost any likely path for U.S. interest rates will leave the Federal Reserve owning as much as $600 billion in mortgage bonds a decade from now, according to new U.S. central bank research that could bolster a case for selling the securities outright to meet a goal of a bond portfolio composed mostly of Treasuries.
The research, published last week, argued that whether interest rates are higher, lower or in line with a rate path consistent with what central bankers expected as of June, the Fed will struggle to shed the mortgage bonds it owns by allowing a certain amount to mature without being replaced each month. Unlike government bonds held by the central bank, Fed-owned mortgage-backed securities (MBS) face little risk of being retired early given the very low rates seen on those bonds.
The authors of the paper note that almost all of the Fed’s MBS holdings have interest rates of less than 4%, well below current yields. That means homeowners whose low-rate mortgages underlay the bonds are unlikely to refinance their loans and or sell their homes and look to buy new ones – the so-called “lock-in effect.”
“Even a notable decline in mortgage rates would likely not materially affect” this dynamic, the authors wrote.
Since 2022 the Fed has been shrinking the size of its balance sheet by allowing the Treasuries and mortgage bonds it owns to mature and not be replaced. That’s taken the overall size of Fed holdings from a $9 trillion peak to its current level of $7.2 trillion.
Balance sheet contraction, known as quantitative tightening (QT), is part of a process of normalizing the overall stance of monetary after the COVID-19 pandemic. The Fed is seeking to reduce liquidity to levels it deems enough to give it firm control over short-term rates and to allow for normal money market volatility, and it remains unsure how far it will have to go to do so.
It also wants to return to a stance in which its bond holdings are made up mainly of Treasury securities. As of July, market participants expected the Fed’s QT to end in April, although they expect the central bank to continue to allow mortgages to expire without being replaced.
Fed officials have also sought to separate QT from what’s happening with interest rate policy, which is now pointed toward an extended series of cuts after the central bank’s decision last week to reduce borrowing costs by half a percentage point.
ACTIVE SALES POSSIBLE
The Fed currently owns $2.3 trillion in mortgage bonds, down from its peak of $2.7 trillion, with most of the progress in QT progress due to drawdowns of Treasury bonds. The paper said that if interest rates decline consistent with early summer expectations, the Fed’s mortgage holdings will ebb to $1.2 trillion by the end of 2030 and $700 billion by the close of 2035.
If interest rates are lower than expected, the 2030 level will still be the same and Fed mortgage holdings will hit $600 billion by the end of 2035.
The challenges the central bank faces on the mortgage bond front have kept alive the idea that at some point in the future it may have to consider active sales, although officials have yet to say much about that prospect.
Given the paper’s findings, the Fed “might be motivated to consider (mortgage bond) sales more seriously, even if on a small scale,” said Derek Tang, an analyst with research firm LHMeyer. “Otherwise, they would be stuck with these holdings for a while.”
(Reporting by Michael S. Derby; Editing by Paul Simao)
From: Yahoo.com
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