Federal Reserve to Stop MBS Reinvestments in 2018 – Morgan Stanley

Morgan Stanley | GoRIon Blog

The Federal Reserve is on course to end reinvestments of its mortgage-backed securities (MBS) holdings next year, as policymakers attempt to shrink a balance sheet that swelled following the financial crisis, analysts at Morgan Stanley recently predicted.

Since the financial crisis, the Fed’s balance sheet has ballooned to $4.2 trillion, or roughly one-fifth of GDP, as officials unleashed record rounds of quantitative easing to boost the economy. Central bankers ended their monthly bond-buying program in October 2014, with the aim of gradually normalizing monetary policy over time. Under current Fed Chair Janet Yellen, the central bank has raised interest rates on two occasions, bringing the target for the federal funds rate to between 0.5% and 0.75%.

The central bank currently holds around $1.76 trillion in MBS. Its Treasury portfolio is worth roughly $2.46 trillion.

Policymakers have yet to comment on ending MBS reinvestments. In a statement after the Jan. 31-Feb. 1 Federal Open Market Committee (FOMC) meeting, the central bank said it would “reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities.”[1]

Analysts at Morgan Stanley say the Fed will end its MBS reinvestments in April 2018, based on the central bank’s projected 3% longer-run equilibrium interest rate. Markets are pricing in three interest rate increases this year, followed by an additional two or three in 2018.[2]

Fed officials, who last voted to raise rates in December, are expected to hike again at the end of next week’s FOMC meeting. Fed Fund futures prices imply a nearly 80% chance of liftoff next week. The market’s certainty comes after a parade of Fed speakers last week said the case for normalizing monetary policy had strengthened since the Nov. 8 election.

In a speech on Mar. 3, Janet Yellen gave her clearest signal yet that rates will rise this month.

“At our meeting later this month, the committee will evaluate whether employment and inflation are continuing to evolve in line with our expectations, in which case a further adjustment of the federal funds rate would likely be appropriate,” Yellen said in prepared remarks at the Executives’ Club of Chicago.[3]

The Fed is under growing pressure from the White House and Congress to shrink its bloated balance. President Donald Trump and Congressional Republicans have repeatedly criticized the central bank for its ultra-loose monetary policy since the crisis. Trump has gone so far as to say the institution was too “political” in keeping rates ultra-low for so long, and that Yellen should be “ashamed of herself.”[4]

Although the economy has regained momentum since the crisis, annual GDP growth has failed to crack 3% for the past 11 years. Growth slowed to a meager 1.6% in 2016, the slowest in five years. For many in the GOP, growth remains feeble despite the Fed’s record stimulus program.

The Fed’s 10-year commercial mortgage MBS is set to expire this year, leading some analysts to conclude that the mortgage market could experience a decline as rising interest rates squeeze cash-strapped borrowers. Mortgage 

rates have increased sharply since the election, and are expected to hover between 4.5% and 5% for the remainder of the year. So far, the housing market has been resilient in the face of rising costs, although this is largely due to razor thin inventories.

By stopping reinvestments in MBS, the Fed can more easily manage its budget than if it stopped reinvesting in Treasuries. By cutting reinvestments, however, the Fed also risks sending mortgage rates higher. The market’s euphoria since Trump’s election win suggests many believe the GOP’s pro-growth agenda will offset rising borrowing costs in the short-term.

Since Trump took office, the economy has seen a sharp rise in inflation expectations, which has spurred actual price growth. The Commerce Department’s measure of CPI inflation rose to nearly four-year highs in January. Core PCE – the Fed’s preferred measure of inflation – is also approaching the 2% target.

 

[1] Federal Reserve Press Release (February 1, 2017).

[2] Reuters (January 27, 2017). “Fed to stop mortgage reinvestments in 2018: Morgan Stanley.”

[3] Lindsay Dunsmuir and Howard Schneider (March 3, 2017). “Yellen points to March rate hike as Fed signals end of easy money.”

[4] Associated Press (February 13, 2017). “Trump thinks Fed is political, has criticized leader Yellen.” Portland Press Herald.

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Sam Bourgi

Sam Bourgi

Sam Bourgi has more than seven years of progressive experience in economic analysis, market research, public policy and the financial markets. He has a broad expertise in the financial markets, including commodities, real estate the foreign exchange. As a published author in both peer reviewed and industry research, Sam has covered topics ranging from mortgage-backed securities to consumer spending and labor. Sam's resume includes more than 40 government and industry publications, thousands of financial articles and hours of educational resources on personal finance and trading.

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