By the Numbers
Flatter yield curve could weigh on bank demand for MBS
This material is a Marketing Communication and does not constitute Independent Investment Research.
Bond investors showed some surprise at the hawkish tone of by the newly minted Federal Reserve Chair Kevin Warsh at his inaugural meeting this month. That surprise translated into a further bear flattening of the yield curve. The pronounced, continued flattening of the curve could further translate into weaker depository demand for pools. But past isn’t always prologue, and floating rate CMOs may continue to find favor with banks.
In the wake of the June FOMC, yields on the front end of the curve came under pressure, with 2-year yields higher by roughly 15 bp. The selloff pushed the spread between 2-and 10-year rates tighter by roughly 13 bp to just a 29 bp yield differential between the two benchmarks, the tightest it has been in more than a year. Spreads between 5- and 30-year yields tightened as well, falling from 78 bp to 65 bp. A flatter yield curve has historically spelled weaker bank demand for MBS from depositories as a flatter curve squeezes the net interest margin (NIM) between assets and liabilities, particularly in the securities book where wholesale bond purchases are more likely to be funded with liabilities with a higher beta to short-term rates than their book of core deposits.
The shape of the yield curve has been related to bank demand
Historically, the shape of the yield curve has been related to bank demand for MBS. Like any levered MBS investor, depositories can generate a better return on equity when asset yields substantially outstrip funding and hedging costs. Given the fact that banks often run a meaningful gap between the duration of their assets and liabilities, banks generally buy more when the curve is steep and less when the curve is flat (Exhibit 1).
Exhibit 1: Bank demand increases as the yield curve steepens
Source: Santander US Capital Markets, Federal Reserve H.8, Bloomberg LP
Admittedly, the shape of the yield curve is not the sole deciding factor that drives MBS demand from depositories. The absolute level of rates will play a role as well as there is a strong negative correlation between the level of rates and deposit growth, meaning that as rates fall, deposit growth tends to accelerate. This is largely attributable to the fact that depositors are more inclined to keep cash on deposit at a bank if the return on investing that cash is relatively low or the prospects of investments being worth less in the future is high.
Additional factors matter as well. The level of systemic liquidity has certainly helped shape bank demand in the past as evidenced during the Covid experience, where the Federal Reserve pumped upwards of $7 trillion of excess liquidity into the system. Most of the Covid liquidity found its way to bank balance sheets in the from of deposits and excess reserves, which banks invested in MBS against the backdrop of heightened economic uncertainty. That drove lending and credit availability to levels not seen since the aftermath of the Global Financial Crisis.
The counterpoint: Why banks may continue to buy…
Depositories’ MBS holdings have significantly retrenched from peak. In the third quarter of 2021, banks owned nearly 40% of the outstanding float of MBS. At the end of the first quarter, they owned slightly more than 30%, in line with pre-Covid readings. So while bank demand may not be particularly robust, it appears likely that, at a minimum, it will keep pace with any further growth in the MBS market (Exhibit 2).
Exhibit 2: Banks hold roughly 30% of all outstanding MBS, consistent with longer term trends
Source: Santander US Capital Markets, Federal Reserve Z.1. Flow of Funds Report
The role of banks’ investment portfolios has changed drastically in the wake of the failures of Silicon Valley, Signature and other smaller depositories in the first quarter of 2023. Larger depositories now view the investment portfolio more as a source of liquidity and interest rate management than a critical driver of earnings. Portfolios have been significantly de-risked, holding substantially more floating-rate and convex exposures than they did in the runup to these bank failures. Given this, the current paradigm of a front-end bear flattening of the yield curve may, somewhat counterintuitively, keep bank demand elevated, particularly for floating rate CMOs which could outperform pass-throughs if the curve flattens further.
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