By the Numbers
What’s driving the tightening in MBS spreads?
This material is a Marketing Communication and does not constitute Independent Investment Research.
Current coupon MBS spreads recently touched the tightest levels of the past three years, tighter by roughly 25 bp since the beginning of the month. A more dovish Fed, a steeper yield curve, delta hedging needs and fund inflows look like clear drivers of recent MBS performance. But potential demand from the Fed and Fannie Mae and Freddie Mac are also important if more abstract catalysts for tighter MBS spreads.
Nominal MBS current coupon spreads closed at just 116 bp within the last week, a level last seen in a pronounced albeit brief tightening in August 2022. MBS spreads had been gradually grinding tighter as they tracked the post-Liberation Day drop in rate volatility. However, the recent gap tighter is likely fueled by more than just the lowest rate volatility readings in roughly three years (Exhibit 1).
Exhibit 1: Spreads tighten as volatility drops
Source: Santander US Capital Markets, Bloomberg LP
A steeper curve should translate to more MBS buying…
At the September FOMC release, the 2025 median dot projection fell to 3.625%, implying 25 bp cuts in both October and December. The recasting of the dot plot was the culmination of market expectations that the Fed would cut three times this year. Some element of recent MBS tightening should be attributed to expectations that lower front-end rates will improve MBS carry and drive more demand from depositories and other levered investors like REITs and hedge funds. It is not difficult to draw a connection between the slope of the yield curve and bank demand for MBS as bank holdings of MBS tend to grow faster against a steeper yield curve and slower against a flatter one (Exhibit 2). Embedded in market-based expectations for a more dovish Fed is the underpinning assumption that a steeper curve and low levels of rate volatility creates somewhat of a Goldilocks scenario for MBS.
Exhibit 2: Banks buy more MBS against a steeper yield curve
Source: Santander US Capital Markets, Federal Reserve H.8, Bloomberg LP
Delta hedging needs drove demand for MBS as well
The bull flattening of the yield curve in the wake of the most recent non-farm payroll release pushed long yields down and mortgage rates along with them. Based on estimates by my colleague Brian Landy, the move from a 6.5% to 6.1% primary mortgage rate roughly doubled the amount of the MBS universe that is currently refinanceable from 4.5% to 10.7% of the universe. The move lower in rates reduced the duration of the Bloomberg MBS index by roughly one third of a year, leaving the index the most negatively convex in three years (Exhibit 3).
Exhibit 3: The MBS universe shortens and becomes more negatively convex
Source: Santander US Capital Markets, Bloomberg LP
Brian’s analysis estimates that at current rate levels, roughly 50% of the conventional 6.0% cohort is in-the-money while just 10% of the 5.5% cohort is currently refinanceable and that a push to a 5.5% primary rate would once again double the float of in-the-money MBS to slightly less than 21%.
With that said, it appears the universe may be approaching peak negative convexity. Based on YieldBook metrics, conventional TBA 5.0%s and 5.5% carry convexity of -2.5 years and are the most negatively convex coupons in the stack. A further rally in mortgage rates would make 5.5%s less negatively convex, looking more like conventional 6.0%s which have a convexity measure of -1.9. Conversely conventional 4.5% would become more negatively convex but given the somewhat bimodal nature of the coupon stack, the overall convexity of the universe may improve modestly into a further rally.
Fund inflows provide further support to MBS spreads
Another factor contributing to tighter MBS spreads are elevated fund inflows. Net inflows into ETFs benchmarked to the Bloomberg US Aggregate Index totaled nearly $21 billion over the past month, which should be invested in MBS proportional to their weighting in the Index. The past month saw an additional $14 billion in government and mortgage-backed ETFs over the past month. Fund inflows to actively managed benchmarked funds threw even more weight behind the tightening in MBS spreads given substantial MBS over-weights in the largest actively managed benchmarked funds.
Thoughts on demand from the Fed, Fannie Mae and Freddie Mac
Some market participants have speculated that the rally has been fueled, to some degree, not only by more dovish Fed positioning with regards to the policy rate but to the portfolio as well and that the end to QT may be nigh. Holding the size of the Fed’s portfolio constant would reduce MBS supply by roughly $18 billion a month in runoff that is not currently being reinvested. An article published by portfolio managers at PIMCO this week suggests that the Fed could take the end of QT one step further, not only reinvesting runoff proceeds in current coupon MBS but actively selling an additional $20 billion to $30 billion of existing discounted portfolio holdings and reinvesting those proceeds in current coupon MBS, which they dubbed “Operation Mortgage Twist.” The authors estimate that the “twist” could both lower primary mortgage rates by 40 bp to 50 bp while also reducing the duration of the Fed’s MBS holdings. The rub, the Fed does not hedge their portfolio, meaning selling discount MBS could crystalize as much as a 20-point loss on deeply discounted MBS held at book value. And while these assets are currently negative carry on the Fed’s balance sheet given the current level of Interest on Reserve Balances (IORB), that negative carry would be reduced fairly materially if the Fed were to embark on a more aggressive reduction in the policy rate. So, while novel and potentially effective in reducing mortgage rates, it seems unlikely that the Fed will actively sell discount coupon MBS out of the portfolio.
In contrast, the idea that Fannie Mae and Freddie Mac could ‘turn those machines back on’ and begin growing their investment portfolios seems more plausible, particularly if and when they offer new common shares in a move away from conservatorship. In their current form, the Preferred Stock Purchase Agreements allow each of the Enterprises to grow their investment portfolios to $225 billion. And at the end of the second quarter, both Fannie Mae and Freddie Mac’s portfolios were well below their caps, holding $81 billion and $65 billion respectively giving them significant runway to grow the portfolios. Our previous pro-forma balance sheet analysis projected that, under a 4.0% leverage ratio, that the GSE may have to collectively grow their portfolios by upwards of $230 billion to generate a mid-teens return on equity assuming no increases to the base guarantee fee or expansion of the footprint of loans they currently guarantee. The estimate likely implies the high end of the range for potential portfolio growth, but based on current revenues it appears the enterprises will need to bolster net income to some degree in any move towards privatization. The portfolios feel like the obvious place to do so given both the institutional expertise in managing mortgage risk and lack of operational frictions to increasing their presence in the MBS market.
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