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
This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.
Important Disclaimers
Copyright © 2023 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.
In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.
The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.
In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.
Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.
