Unprecedented Treasury supply dominates agency MBS story for 2024

The enormous Treasury issuance expected next year forms a long shadow falling over the agency MBS market, say investors.

Estimated 10-year Treasury issuance is now projected to be US$1.34trn in 2024, some US$90bn more than earlier estimates and breaking previous records. Assuming the Federal Reserve extends quantitative tightening, overall 10-year Treasury supply will exceed US$1.5trn.

“The biggest risk to agency MBS is Treasury supply. It’s all competing for the same finite number of dollars. So far, the Fed’s reserve repo has absorbed quantitative tightening but when this is exhausted it will impact bank reserves,” says Brendan Doucette, securitized analyst and government bond portfolio manager at GW&K Investment Management in Boston. Doucette manages a US$1.5bn portfolio of agency MBS assets, part of a wider US$5bn risk-free portfolio.

The US debt to GDP ratio is now over 120%, more than 20% greater than four years ago. Moreover, higher interest rates mean debt service payments are climbing ever higher, making even more issuance necessary.

There are, of course, some significant tailwinds for the agency MBS market as well. Issuance has been much lower as the mortgage and refinancing market has gone into deep freeze. Total agency MBS issuance this year is expected to be around US$1trn, compared to US$1.7trn in 2022 and $3.5trn in 2021.

Higher rates have made agency paper more attractive, and inflation appears to be heading in the right direction. Volatility has also declined. But all this is more than counter-balanced by the overhang of Treasury issuance coming due next year.

Current coupon spreads over seven-year Treasuries hit a post-GFC high of 194bp in May of this year in the wake of the banking failures of the spring, which triggered a round of asset sales. Rate volatility was also at the highs of the year.

Since then spreads have retreated to plus 159bp, and, as refinancing continue to plummet and vol has diminished further, they may settle in the plus 145bp range by end of Q1, suggests Doucette. But he is reluctant to predict any further narrowing thanks to the weight of expected Treasury supply.

Another issue with which the agency MBS market must contend is the absence of bank buyers. As the Fed raised rates, banks have been left with significant mark to market losses on risk free assets. It was this phenomenon, allied to the need to pay higher yields of short-term deposits, that torpedoed Silicon Valley Bank in March. It has been estimated that the big Wall Street houses are sitting on US$650bn of unrealized losses. This does not tempt them back into the risk-free market.

“If banks don’t come back into the market, spreads will have to remain elevated to be more in line with alternative investments,” says Doucette.

It was the unexpected round of bank sales in the spring, leaving the market with another US$1bn to absorb, that sent spreads soaring in the spring and banks haven’t come back in.

There are, according to Doucette, some signs that overseas buyers are starting to show interest, and money managers have increased their holdings as well, but it has not been sufficient to offset the absence of bank buyers.

“We’ve seen some foreign buyers but the big question is when are the banks coming back. Their portfolios are paying down and rate vol has come down as well, so there are some reasons to be optimistic,” he says.

Simon Boughey