This week the Federal Reserve (Fed) is back in the spotlight after Fed Chair Janet Yellen raised interest rates in response to continued strength in the U.S. economy. Worries regarding the expanding girth of the Fed’s balance sheet have moved to the back burner, as the markets have turned their focus to improving economic growth prospects under the Trump Administration. However, the large move in rates this year has had a dramatic effect on the Fed’s book of agency mortgage-backed securities (MBS), which makes up $1.7 trillion of the Fed’s balance sheet.
The Fed’s largest exposure to agency MBS is in Fannie Mae 30-year mortgage pools, which represent 40.7% of the Fed’s total agency MBS exposure. Additionally, the weighted-average coupon of their agency MBS book across all tenors and product types is 3.4. Taking these two aspects into consideration supports the use of the FNMA 3.5 security as a reasonable proxy for the Fed’s agency MBS book. This week’s chart shows the connection between the 10-year U.S. Treasury yield and the FNCL 3.5 option-adjusted duration (OAD). The dramatic rise of the FNMA 3.5 OAD—from less than 2 years to now approaching 5 years—is concerning. This extension is a function of refinancing-related pre-payments decreasing as rates rise. FNMA 3.5 yields increased by roughly 1% over the past 6 months, corresponding with a 3-point dollar price drop. A 3-point dollar price drop on a book of $1.7 trillion gives a loss of approximately $50 billion in value!
Key Takeaway:
Rising rates pose increasing duration risk to certain fixed-rate assets, primarily those exhibiting negative convexity, such as 30-year agency MBS. The Fed was a major buyer of these types of securities during its quantitative easing program, as they sought to stabilize the U.S. economy. It is looking like the Fed was successful in achieving this economic stabilization, but now their balance sheet bears the scars of the dramatic actions they took to accomplish that goal. The markets may not present the Fed with a good exit point, in which case the divestment of agency MBS could turn out to be quite painful for the Fed.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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