Leading agency MBS buyer talks taper, inflation and origination

While the encroach of inflationary pressures and the Fed taper will be important factors to consider, the dominant fundamental influence upon MBS in the medium term will be supply, says Brendan Doucette, portfolio manager for GW&K.

Doucette manages an agency MBS portfolio valued at $1.5bn at the end of Q3 2021, up from $1.2bn at yearend 2020. GW&K has over $48bn assets under management.

The US house market has been at white heat this year in many parts of the country, and significant supply has meant significant origination. Over $700bn has printed in the agency MBS market so far this year, and it is on course to print a record $800bn.

This level of supply has been the major influence upon the MBS market this year, in spite of the increasing presence of inflation and the Fed taper - which kicks next month at a rate of $5bn less per month.

While new mortgages are unlikely to maintain quite the same rate in 2021, origination is likely to remain elevated. Home prices have increased 20% this year, and while continuing upward momentum will on the one hand cool new debt applications it will also promote cash-out refinancing, further supporting origination.

Doucette estimates that the agency MBS market will print perhaps $600bn next year - off this year’s pace but still very lively.

In the near term, however, the technicals appear to support narrower spreads. Supply and thus issuance traditionally slows down at the end of the year, while higher mortgage rates have temporarily dampened the refi index.

Indeed, shortly after the Federal Reserve first indicated at the end of September it was ready to start tapering, spreads narrowed, perhaps counter-intuitively. The current coupon spread to the interpolated five-year/10-year Treasury curve was 75bp before the announcement and is now 64bp after hitting a low of 61bp at the end of last month.

The technical impact of the yearend shortage in supply was galvanized by a relief rally as the market finally had some clarity about when the taper would start, how much it would be for and how long it would last.

However, as the taper begins to take a grip of the market next year, spreads could drift wider.  Consequently, Doucette prefers defensive stance on spread duration.

“We are neutral on MBS in terms of weighting versus the index but we prefer to be defensive and underweight in rate and spread duration. The seasonal slowdown will help offset the first leg of the taper but there are unknowns heading into next year,” he says.

One such unknown is whether the Fed will start investing paydowns back into the Treasury market, If it does, MBS spreads to risk-free rates could widen once more.

The uncertainty surrounding the impact of Fed lack of buying leads GW&K to eschew areas of the market in which the central bank is historically most active. For example, the Fed dominates the 2% and 2.5% coupons in 30-year MBS. As they retreat from the regular monthly bid, this is the area of the curve which could see widening.

“We’re owning coupons where the Fed doesn’t own the float. We want to own higher coupons. The moral is: don’t own what the Fed does,” says Doucette.

The third spoke in the wheel is of course inflation. Fed chairman Powell has repeatedly sought to allay concerns by calling inflation “transitory” but it looks increasingly as if that is wishful thinking. According to a Goldman Sachs research report released on Sunday night, prolonged supply chain imbalances and rising wages mean that inflation metrics will remain “quite high for much of next year.”

The latest personal consumption expenditures price index - the Fed’s preferred inflation gauge - showed prices rose 3.6% in August and September. This is the fastest rate for 30 years.

While the dominant influence upon the MBS market over the next year is likely to be origination, inflation is sure to play a large role.

“Recent rate volatility leads us to be underweight rate duration. We would want to be long duration as the Fed hikes rates and the curve flattens. But right now there is too much day to day rate vol,” he says.

Simon Boughey