Wednesday, September 27, 2023
With the Federal Reserve (Fed) aggressively raising short-term interest rates in an effort to arrest generationally high inflation, interest rates across the U.S. Treasury yield curve have moved higher in concert. The move higher in Treasury yields has put upward pressure on most other business and consumer interest rates including residential mortgage rates. Last week the 30-year fixed national average rate for U.S. borrowers jumped to 7.41%, which is the highest level since 2000. Higher rates have certainly impacted the demand for housing. The release of today’s MBA mortgage applications index showed that home purchases and refinancing activity continue to fall with the broader index at its lowest level in decades. Moreover, purchase activity is down 27.3% year over year and refinancing activity lower by 21.4% year over year.
Within the fixed income markets, mortgage loans that are bundled and sold to investors are a big component of the core bond universe. Agency mortgage-backed securities (MBS) are the second largest sector (behind Treasury securities) so a slowing housing market impacts the MBS market as well, specifically the amount of new MBS supply coming to market. Gross issuance has fallen significantly from the elevated levels seen back in 2021 and even 2022. Furthermore, seasonality trends would suggest overall issuance should slow further into the fall. The lack of supply should be supportive of existing MBS prices.
We continue to think the risk/reward for Agency MBS is attractive, particularly relative to lower rated corporate credit. Yields and spreads (or the additional compensation for owning debt riskier than U.S. Treasuries) remain elevated relative to historical averages and with the Fed close to the end of its rate hiking campaign, falling interest rate volatility could be a tailwind to the asset class. And while the Fed will continue to reduce its $2.5 trillion MBS ownership stake (the Fed is currently allowing up to $35 billion of MBS to passively roll off its balance sheet), we’ll likely see traditional MBS investors (mutual funds, banks, foreign investors) re-enter the market as they were crowded out due to Fed purchases. Moreover, the relative attractiveness of MBS versus high-grade corporates has improved to the point that investors may choose the AAA-rated paper with very little credit risk over the BBB-rated corporate paper that may experience elevated risks during an economic slowdown. As such, we remain overweight MBS in our recommended tactical asset allocation for fixed income.
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