Federal Reserve’s ‘tapering’ plan will open up space in the secondary market

Whether new buyers will emerge to replace the Fed MBS purchases is up to market forces

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The Federal Reserve in September signaled that it plans to begin unwinding, or tapering, its nearly $8 trillion portfolio of mortgage-backed securities (MBS) and Treasury holdings as early as November, assuming the economy stays on track as expected. 

On the MBS side, which now represents about $2.5 trillion in securities held, observers believe the Fed will move cautiously – the Fed is expected to slowly reduce the level of new asset purchases while continuing to replace assets that have matured and run off the books. The central bank also can reverse course at any time and expand its MBS portfolio should economic conditions change. That’s the consensus of a group of economists interviewed this week by HousingWire.

In fact, stepping back into the secondary market is precisely what the Federal Reserve did in March and April of 2020, when the pandemic first choked the economy. The Federal Reserve became essentially the sole player in the MBS market over those two months, gobbling up $587.3 billion in MBS assets to help stabilize the market and spare the nation another major financial crisis. 

“You hear them [the Fed] talk about doing what’s necessary to continue the smooth functioning of the market, and that was the main motivation for them entering in the spring of 2020,” said Mike Fratantoni, chief economist and senior vice president of research and industry technology for the Mortgage Bankers Association. “The market was in danger of just shutting down because buyers and sellers were so far apart, and they couldn’t find a price to trade. So, you saw trading volume drop pretty sharply and wild swings in pricing.” 

Fratantoni noted that interest rates in the primary market, for homebuyers, are set based on yields in the secondary market. “It gets pretty difficult to conduct any business when the markets aren’t functioning, so the Fed moved in with enough force to get the markets flowing again,” he said.

In the case of the Federal Reserve’s existing and still-growing $2.5 trillion mortgage-backed securities portfolio, the expectation is that the Fed will continue to replace so-called asset “runoffs” as they mature. That will occur even as the Fed tapers, or reduces, its new MBS asset purchase pace of $40 billion a month. 

The tapering of those new purchases will likely occur at a pace of $5 billion a month over eight months, according to Fratantoni and Laurie Goodman, vice president of housing finance policy and the founder of the Housing Finance Policy Center at the Urban Institute

That means the actual effect of the tapering on the housing market, including interest rates, should be modest — even if new MBS purchases completely wind down by next June or July as expected.

“In August [2021], the Fed purchased a total of $91 billion in MBS,” Goodman said. “That’s $40 billion in new purchases and $51 billion was to replace [MBS asset] runoff.

“So, they will still be replacing runoff [under this coming wave of tapering], and runoff is very heavy right now because interest rates are low [propelling what has been a strong refinance market]. But as rates rise, because the economy will be in better shape, then the record amount of runoff decreases.”

Consequently, the broad economic impact of the coming tapering is expected to be more like the Fed taking its foot off the gas pedal for a spell as opposed to hitting the brakes hard, according to the economists who spoke with HousingWire.

For now, the Fed has the gas pedal pressed down, Fratantoni said. “But they’re easing their foot off it,” he added. “And while they would quibble with the analogy, I think markets are anticipating that if the Fed is saying the first interest rate hike will occur as soon as the end of 2022, [then] if that’s tapping on the brake, they want to make sure the foot is off the gas pedal [with tapering] before they start tapping that brake.”

The most likely scenario, according to Lawrence Yun, chief economist at the National Association of Realtors, is that “we will just see a gradual and steady rise in mortgage rates.”

What could shock the economy and cause a spike in interest rates, he adds, is if the inflation rate increases at a rapid pace.

“It has been extraordinary to observe sub-3% mortgage rates for quite some time, since the onset of the pandemic,” Yun added. “The economy is steadily recovering, and inflation is kicking higher. Mortgage rates will steadily rise, possibly to 3.3% by the year-end, and maybe even as high as 3.7% by the end of 2022.”

MBA’s Fratantoni estimates that rates could reach 4% by the end of 2022. 

As far as what will happen in the MBS world, Yun expects market forces to control the day once the Fed retreats as a steady buyer of those assets.

“Fannie [Mae] and Freddie [Mac] will just have to find other buyers, like Wall Street, the Chinese government or German mutual funds, while offering slightly higher interest rates,” Yun said. “The ability to find other buyers will determine how much higher those interest rates will be. That interest rate will then filter down to consumers.”

Ray Perryman, president and CEO of the Perryman Group, an economic research and analysis firm based in Texas, noted that mortgage rates — including any upward pressure the Fed’s tapering may cause — are not the only factor affecting housing affordability. He says a major supply and demand imbalance also is now at play in the housing market. 

Supply has been constrained because of labor and material shortages, and other constraints, he said, all sparked by the pandemic. Demand for housing has also increased, he added, “for a variety of reasons, ranging from population growth to changing needs due to remote work and school.” 

Those dual forces, supply shortages and high demand, are putting upward pressure on home prices, Perryman contends — and more broadly fueling inflation across the economy. In that light, he said it is the right time for the Fed to act and get in front of the problem.

“It is important for the Fed to take action to taper and begin to return to a more normal policy stance to help prevent excessive inflation and to allow room for action in the future,” he stressed. “While there could be some short-term (indirect) effects on interest rates, the longer-term view clearly indicates that overly expansive [Fed] policy will ultimately be harmful to households, businesses and the economy.”

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