By the Numbers
Charting the course of Fed MBS portfolio runoff
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.
The Federal Open Market Committee signaled Wednesday that the Fed could start reducing the size of its MBS portfolio this year. After tapering ends in March and hikes begin, portfolio runoff will follow. When the Fed last allowed portfolio runoff in 2017, it capped the pace at $20 billion a month. But that cap is likely to be too low over the next three to five years. The Fed may need to permit runoff of more than $30 billion a month. That would raise effective net MBS supply from around $60 billion a month to around $90 billion.
At today’s interest rates the MBS portfolio should shrink $375 billion over the next year if the Fed does not reinvest any paydowns (Exhibit 1). This includes scheduled principal payments and prepayments. In five years, the portfolio should shrink by $1,392 billion, which is slightly more than 50%. The pace of principal return continues to slow after five years, and the average life of the portfolio is expected to be 80 months.
Exhibit 1. Projected principal paydowns of the Fed MBS portfolio
Assumes no paydowns are reinvested.
Source: Federal Reserve, Yield Book, Amherst Pierpont Securities
The pace of paydowns depends on the level of interest rates, of course. But even if interest rates fall 50 bp, the portfolio would only runoff 60% over the next five years, a 10% increase over the base case (Exhibit 2). Many of the Fed’s pools now trade at or below par and have moved out-of-the-money to refinance as interest rates increased over the last few weeks. Fed holdings in lower coupons and the rise in rates has lowered the rate sensitivity of the portfolio.
Exhibit 2. The MBS portfolio is likely to paydown 40% to 60% in next five years
Assumes no paydowns are reinvested.
Source: Federal Reserve, Yield Book, Amherst Pierpont Securities
The Fed outlined some principles that would guide balance sheet reduction in a separate statement. The Fed plans to reduce holdings in a predictable manner, and in the longer run intends to own primarily Treasury securities. But unless interest rates fall the Fed is likely to own more than $1 trillion MBS in five to seven years (Exhibit 3). This suggests that the Fed will likely cap MBS runoff much higher than $20 billion monthly. In the base case, runoff could average $31 billion monthly in the first year and $27 billion monthly over the first three years. The cap consequently could be set at $30 billion or higher, otherwise the Fed will have difficulty achieving its goal of owning primarily Treasury securities. In fact, the pace of runoff could be slow enough that the Fed may eventually contemplate outright MBS sales.
Exhibit 3. The Fed portfolio is likely to exceed $1 trillion in 5 to 7 years
Assumes no paydowns are reinvested.
Source: Federal Reserve, Yield Book, Amherst Pierpont Securities
Brian Landy, CFA
blandy@santander.us
1 (646) 776-7795
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