Fed hits investors with MBS game changer
Ben Bernanke and the Federal Reserve seem a bit more hawkish about tapering the Fed's bond-buying program — a development that would be a major game changer for securitized products.
With the labor market still extremely volatile, market experts believe that allowing for early tapering of mortgage-backed securities by the Fed would prove premature.
However, a different message was delivered last week. Bernanke believes that due to optimism about home price gains, housing should be able to absorb increasing mortgage rates, according to Bank of America Merrill Lynch (BAC).
For instance, the 30-year, fixed-rate mortgage stood at 4.24% in the most recent Bankrate report, indicating the Fed assumption is a 5% mortgage rate would be acceptable.
"Therefore, Bernanke’s comment suggests to us that at least another 75 basis points rise in mortgage rates can be expected, as the market is likely to test the chairman’s resolve in his willingness to taper in the face of higher mortgage rates," said Chris Flanagan and Adam Katz, MBS strategists for BofAML.
They added, "We would expect that this increase would pass through to agency MBS yields — obviously, a negative."
The eventual winding down of the Fed’s bond-buying program was a negative broadly for securitized products, with agency MBS interest only perhaps the only beneficiary.
At this point, the chances are good for a temporary rally over the next one to two months, but investors should use that as an opportunity to reduce risk, the report says.
In the near term, there is a meaningful potential for a bounce in bonds, but longer term, yields and spreads will likely move higher from current levels, according to the research note.
"Given that securitized products spreads have been correlated with yields, our takeaway from this analysis is that the market is likely to give an opportunity to reduce risk over the next two months," BofAML analysts explained.
They added, "Our recommendation is to slowly take advantage of the opportunity as the anticipated bear market rally unfolds."
As the taper date for MBS purchases draws closer, these bonds likely will lead the way to higher yields and spreads, the same analysts suggest.
As a result, higher yielding sectors such as private-label MBS and commercial mortgage-backed securities will be forced to adjust higher in yield and spread.
"That process has already unfolded more quickly than we had anticipated," Flanagan and Katz concluded.