North of Boston, the ocean depth can drop off precipitously close to the shoreline. This dramatic sub-surface gradient can amplify the rolling forces of Atlantic Ocean waves as they approach shore, strengthening the push of surface waves towards the beach while amplifying the pull of subsurface water back towards ocean depths. This dynamic is called an “undertow,” and it can sweep unsuspecting beachgoers off their feet, pull them under, and carry them out to sea in mere seconds. It is further heightened by certain environmental factors such as weather, tide, and wind conditions.
Interest rate markets have their own undertows, which can fuel volatility if market conditions are right. The big volatility event in the second quarter of 2013, known as the “taper tantrum”, occurred when long-term interest rates shot up in the wake of Bernanke’s announcement that the Federal Reserve (Fed) planned to reduce its bond purchases at some point in the future. At the time, the Fed was purchasing $45 billion in Treasuries and $40 billion in mortgage-backed securities (MBS) per month as part of their third round of Quantitative Easing (QE3) since the Great Financial Crisis. Fixed income’s messy knee-jerk reaction created ripple effects across the broad economy not desired by the Fed, such as tighter financial conditions for several months.
The fact that markets were surprised by Bernanke’s announcement ignited a vicious spiral of Treasury and MBS selling. When Treasury rates rise, and MBS spreads simultaneously widen, expected mortgage refinancing activity will slow dramatically. This lengthens the anticipated return of principal on MBS holdings and adds duration at the portfolio level undesired by the investor. A subsequent duration rebalance requires more selling of Treasuries, which stokes a further slowdown and further selling.
But each economic downturn is unique, and this one is no different. While the mid-2000’s housing bubble precipitated, fueled, and ultimately crippled the U.S. mortgage industry for years, this economic swoon has had little adverse impact on mortgage quality or credit availability. In fact, demand for single-family homes has risen sharply with social distancing and work-from-home adjustments to daily routines. Yet the Fed’s support for the Treasury and MBS market liquidity via QE4 has pressured mortgage rates to near all-time lows, and one result has been the inflation of national home prices at a double-digit growth rate on a year-over-year basis.
But too much rapid price appreciation in housing could limit affordability, family formation, and worker mobility over the long run. While Fed Chair Jerome Powell has refrained from commenting directly, Eric Rosengren, President of the Boston Fed, recently posed the question as to whether the Fed should continue to support an MBS market that seemingly no longer needs it. This raises the prospect that the Fed might choose to conduct a two-part taper – perhaps curtailing their MBS purchases over the coming quarters while maintaining their current pace of Treasury purchases.
Regardless of the Fed’s specific approach, the market is less prone to duration hedgers today than it was in 2013. The Fed is the largest single holder of MBS (and Treasuries), but they do not actively rebalance their duration. Rather, they buy long-term securities with the intention of holding them to maturity. As a result, their QE purchases effectively retire a portion of the available Treasury and MBS market float for good. Today, the combined Treasury and MBS float is less comprised of MBS (33.6%) than it was in May of 2013 (44.3%). So even if active hedgers behave the same as they did in 2013, the net effect from duration rebalancing should be more muted this time around.
While the undertow risk at the beach is a real danger this summer, we believe fixed income markets have less to fear from the Fed’s taper announcement this time around. Powell is apt to be more careful with his language, the FOMC has the option to take a multi-stage approach, and MBS investors who actively rebalance duration are a smaller portion of the market today than they were in 2013. Of course, other factors can complicate the situation (such as inflation expectations), but as of now, no repeat of 2013 looks to be rolling in.
