Move Likely to Impact Interest Rates, Bond Yields

After being credited for steering the U.S. economy off the precipice in the global financial crisis through its massive stimulus program, the Federal Reserve is now facing the delicate task of paying the bills.

The Fed is preparing to unwind a huge chunk of its $4 trillion portfolio of bond securities it began accumulating 10 years ago, part of the measures it took to prevail over a collapsing economy. This past week, the Fed disclosed plans to gradually reduce its holdings of Treasury and mortgage-backed securities (MBS) beginning sometime between September or December.

The monetary policy body was careful to frame the move as a deliberate continuation of the “normalization” policy it announced back in December 2015 when it first began raising the federal fund borrowing rate.

This next move is not without risk. Reducing such a massive amount of securities likely will impact the corresponding interest rate moves planned by the Fed, and could make mortgage-backed securities less attractive to investors than Treasury bonds.

While the timing of the start of the plan is still to be decided, the Fed has mapped out how much it currently plans to reduce its holdings by each month, the target of reducing its portfolio to a $1.7 trillion target in 2024.

While members of the Fed are in agreement on the need to divest its securities holdings, there is some debate over how the balance sheet reduction will impact the path of interest rates, according to Tate Lacey, a policy analyst at the Cato Institute. Some members believe that the frequency of interest rate increases should slow as its securities roll off. The Fed has increased the rate three times in the last seven months. Other members believe that ‘normalizing’ the Fed’s balance sheet will not materially affect the path of rate hikes.

Justin Bakst, Director, Capital Markets Analytics for CoStar Group, said the Fed will continue  to  closely  monitor  inflation  levels,  which  are  still  below  most economists’ expectations, as well as the impact of the Trump administration’s fiscal policies, to guide its monetary policy actions going forward.

“Even with the potential for Fed normalization, long term interest rates are still 22 basis points below March levels, while the yield curve remains relatively flat,” Bakst noted. “To the extent the [Fed] does begin normalization, we’re not expecting to see a significant impact on interest rates. In that case, the impact to cap rates and real estate values would likely be marginal.”

CoStar analysts also think the measured, gradual reduction will mute the impact on the MBS market.

Jack Mulcahy, Credit Risk Analyst for CoStar GroupJack Mulcahy, a credit risk analyst for CoStar, said CMBS yields have experienced only a very small uptick since the disclosure of the move. Also, CMBS spreads remain tight at 65 bps for investment-grade corporate bonds and 51 bps for CMBS bonds.

“The FOMC has telegraphed the possibility of normalizing the balance sheet to investors. This was talked about in-depth prior to the election and really since 2014. So there’s no surprises here,” Mulcahy said. “Yields in turn have not really reacted… This normalization is built into current pricing. We see no evidence that these reductions will happen in large block size. We see this happening in a gradual and predictable manner.”

Larry Kay, senior director at Kroll Bond Rating Agency, said with the additional mortgage supply coming to market, the 10-Year Treasury rate could see its rate increase, which would not be positive for the CMBS sector. “However the impact may be muted given the current rate of inflation,” Kay added.

CMBS pricing continues to remain favorable for borrowers, who will likely be trying to lock-in rates in advance of the unwinding, Kay said.

By Randyl Drummer