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A bullish case for the MBS basis

| June 12, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Both the Fed and the Treasury have started heading down paths bullish for the performance of MBS against Treasury debt. The Federal Reserve has already purchased $728 billion of MBS through June 11 and has committed to increasing net holdings by $40 billion a month to ensure smooth market functioning. At the same time, the Congressional Budget Office estimates the Treasury will issue $4.5 trillion in additional debt by June of next year. The combination of Fed buying and Treasury supply could tighten the spread between MBS and the Treasury curve toward some of the narrowest levels seen in years.

The basis tightens as the Fed takes a higher share of outstanding MBS

Fed purchases so far have likely helped tighten the basis by at least 24 bp. Fed researchers have modeled the effect of past MBS purchases on the mortgage basis. For every 1% of outstanding MBS purchased by the Fed, MBS yields dropped 2.3 bp. Since March 1, the Fed has purchased $728 billion MBS, which is roughly 10.6% of all MBS outstanding.

The increasing Fed share has almost certainly helped tighten spreads, although par 30-year OAS has tightened by far more than 24 bp (Exhibit 1).  From its widest point on March 19, the par 30-year OAS has run from 150 bp to below 40 bp. The wide print came after the Fed’s March 15 commitment to buy up to $200 billion in agency MBS. On March 23, the Fed committed to buying as much MBS as need to “support smooth market functioning.”  It is hard to know how much the market then assumed for Fed purchases. It is also hard to filter out the impact of other investors buying in concert with the Fed. Frictions in origination caused by the coronavirus along with high unemployment and lower growth this year has also likely reduced expectations for net MBS supply.

Exhibit 1: Par 30-year OAS has tightened with Fed buying and other factors

Source: YieldBook, Amherst Pierpont Securities

The Fed’s June 10 commitment to increase MBS holdings by $40 billion a month with no end date should further tighten the basis. Over the next 12 months the Fed’s MBS portfolio should grow by $480 billion, reaching nearly $2.4 trillion in June 2021. That represents 6.6% of the expected outstanding MBS market, assuming outstanding MBS grows to $7.25 trillion by next June. As a result, the basis should tighten 15 bp. Since the close of business on June 9, the basis has tightened from 39 bp to below 30 bp, nearly pricing in most of a year of purchases. The Fed’s commitment to easy financial conditions should keep MBS purchases in place beyond a year.

Tied up in the Fed program are other reasons the Fed could tighten the basis beyond simply holding MBS. The Fed’s purchases remove negative convexity from the private market balance, lowering volatility in private investors’ portfolios. The Fed also typically takes delivery of the most negatively convex MBS pools, lowering the overall negative convexity of MBS available to private portfolios.

Heavy Treasury supply likely to tighten the basis further

All spread products historically tend to tighten when Treasury supply increases. Several researchers have modeled this relationship.  For example, this World Bank paper estimates that a 0.9% increase in Treasury supply over 12 months lower 10-year swap spreads by 1 bp.

The CBO publishes a quarterly forecast of Treasury supply, which can be used to estimate how much the basis will tighten. The last official forecast predates the response to the pandemic, but the CBO provided some hints to their Treasury forecast in their monthly GDP forecast published April 24. The CBO expects the debt-to-GDP ratio to increase by 20 percentage points by the end of 2020 and by 26 percentage points by the end of 2021, which implies they expect the outstanding treasury debt to reach roughly $22 trillion in June 2021. That is a $4.5 trillion, or 25.7%, increase from the beginning of March.

Based on a model estimate alone, 10-year swap spreads would tighten by roughly 28.5 bp over the next year. If MBS tightens similarly to swaps, or even at half the estimated pace of swaps, the MBS basis would revisit levels last seen in late 2012, just after the Fed announced an open-ended commitment to buying $40 billion a month in MBS.

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