Quantitative easing continues to pump up the Fed’s balance sheet
The Fed’s asset purchase program, also known as quantitative easing (or QE), has swelled the Fed’s balance sheet from under $1 trillion pre-crisis to an all-time high of $3.48 trillion. The Fed has pursued this strategy in order to drive down long-term interest rates. The Fed is able to set rates at the short end of the yield curve directly by setting a target rate for the Federal Funds rate. However, it has historically been powerless to determine long-term rates. Quantitative easing was the Fed’s answer to “What else can we do once interest rates are zero?”
In response to the crisis, the Fed first lowered short-term interest rates and then conducted “Operation Twist,” which was its first attempt to lower long-term interest rates. The Fed would sell its short-term Treasury notes and purchase longer-dated Treasuries with the proceeds. The idea was that the Fed could maintain the same net financial exposure while at the same time pushing down longer-term interest rates. After deciding it needed to do more, the Fed pursued quantitative easing by purchasing Treasuries and mortgage-backed securities directly for its own balance sheet.
How will the Fed unwind the trade?
Quantitative easing has had a beneficial effect on the Fed’s balance sheet. As it pushes down interest rates, the value of the bonds on its balance sheet increases. In fact, the Fed had a profit of $89 billion in 2012, which it paid to the Treasury. The Fed’s P/L is a line item in the US budget. The Fed’s assets are largely long-term Treasuries and mortgage-backed securities. Its liabilities are Federal Reserve notes, or the actual currency in your wallet. It pays no interest on these liabilities, so it makes a decent financing spread, and the value of its assets has been increasing due to its own buying.
The big question relates to how the Fed unwinds the trade. The plan even has a name—Fexit—short for “Fed Exit.” The Fed currently owns about 70% of US Treasuries and has been buying most of the mortgage-backed securities being issued. The Fed has said it doesn’t plan to sell its assets and intends to re-invest maturing bonds into new ones.
The Fed had been guiding the market to expect a reduction in the pace of purchases by the end of the year, and most participants had pegged the September FOMC meeting as the most likely time. The Fed chose not to move at that meeting, which surprised the markets. The Fed seemed to feel tapering was unwarranted based on the economic data. In fact, the only reason it was considered was to boost the credibility of the Fed. After the September move and the subsequent government shutdown, market participants are revising their forecasts, and are now anticipating a Q114 start to tapering.
Implications for mortgage REITs
Any sort of unwinding of QE will precede an increase in short-term rates. If long-term rates rise while short-term rates stay the same, the yield curve will steepen. A steepening yield curve is on net bad news for mortgage REITs, like American Capital (AGNC), Annaly (NLY), MFA Financial (MFA), Capstead (CMO), or Hatteras (HTS). As yields increase, the price of their assets fall, which gives them mark-to-market losses. While a steepening yield curve does increase their interest margins, the mark-to-market losses dominate.
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