QE, Risk Premia and Option Adjusted Spreads
Updated: Mar 17, 2022
Through its expansion of credit policies, the Fed has effectively engaged in fiscal policy actions that more appropriately belong to Congress. Congress, as well as the Fed, have taken actions that violate at least the spirit of the 1951 Accord. Taken together, these actions undermine the independence of monetary policy decision-making by the Fed and open the door to political and fiscal abuse of the central bank’s balance sheet. Thus, it is important to strengthen Fed independence through the appropriate assignment of decision-rights and accountability required of the institution in a democratic society.
"Federal Reserve Independence:
Is it Time for New Treasury-Fed Accord?"
March 15, 2022 | There is a fairly brisk debate ongoing in the fixed income markets over how much the Federal Open Market Committee will reduce the size of its balance sheet over what timeframe. A key component of this discussion is whether or not the Federal Reserve Bank of New York will be required to actually sell agency and government mortgage-backed securities (MBS) next year in order to meet the Committee’s targets.
The basic issue driving this debate, a question that will not be resolved when the FOMC meets this week, is whether the slowdown in mortgage refinance transactions will force the Fed’s hand and compel outright sales of MBS next year. As prepayments slow, the effective maturity of an MBS extends, creating what denizens of the bond market lovingly refer to as “extension risk.” The sudden change in effective duration of securities has been responsible for numerous financial crises over the past 50 years.
Extension risk means that as the effective maturity or duration of a residential mortgage security extends, the pricing becomes more volatile, mostly on the downside, and the investor is deprived of the opportunity to re-invest at higher rates. The S&Ls of the 1980s, for example, were decimated when short-term interest rates rose but the duration of loan assets extended, making it impossible for thrifts to manage interest rate risk. US banks face a similar risk today, but hold that thought.
Source: FDIC/WGA LLC
The history of Wall Street liquidity crises going back 50 years has often included investors who thought they owned an MBS or collateralized mortgage obligation (CMO) with a four- or five-year average life, but awoke one morning to find that the bond now has a 10-year + effective maturity. Hello.
The FOMC owns about half of all MBS issued since 2020, several trillion dollars in total. As one analyst noted last week, the Fed will own these bonds for a long time barring outright sales. Yet the line coming from the Fed is steady as she goes in terms of denying the possibility of outright sales of MBS.
Lori K Logan, EVP of the Federal Reserve Bank of New York, set the stage for the withdrawal of accommodation in an important conversation with David Beckworth this past January:
“At the conclusion of the large-scale asset purchase programs after the global financial crisis, the committee did undertake balance sheet normalization that lasted about two years. So in terms of the mechanics of that process, balance sheet normalization was conducted in a gradual manner and a predictable manner. I think those are the two key themes there. And there were two implementation elements to that. First, principal payments from our maturing securities were no longer reinvested and that reduces the balance sheet size. And in other words, it was an organic process. We didn't sell assets. And then the second mechanical feature was that caps were set on these monthly redemption amounts to ensure a steady decline.”
The war in Ukraine adds another layer to the usually domestic analysis of Fed monetary policy. Most of the economist chorus in the US almost never talks about the rest-of-the-world, but in fact offshore demand for dollars and, equally important, demand for risk-free collateral denominated in dollars is a factor as well. Watch the likes of Softbank of Japan circling the drain of credit and liquidity, then you understand why Asian investors are selling stocks with abandon this week.
In the chart below from Bloomberg, the green line is the Treasury yield curve and the blue line is the bid side of dollar swaps. Notice that the portion of the swaps curve between overnight and 7 years is very well bid. Think anybody on the FOMC will talk about this tomorrow?
While the Russia war of extermination against Ukraine may remove Putin’s kingdom from the global economy, we think the crisis will actually strengthen the dollar’s role as the default means of exchange. Dollars, euros and yen are the only global currencies, managed by free and democratic societies, that matter. And the distinction between onshore and offshore will increasingly divide markets and economies.
Yeah, the dollar will “never be the same” because we’ve chased all of the oligarchs and associated crime organizations back to Moscow. Down the road, Ukraine will become a copy of Austria circa 1955 (h/t John Dizard), sorta an EU member, but outside of NATO by international agreement.
Given the table that has been set for the FOMC, we think the first question is when will the 10-year Treasury peak and maybe touch 2.25%? But our bias remains lower rates because of the persistent foreign demand for liquidity and risk-free assets. Given the chart above, we see 1% on the 10-year Treasury as a likely target.
The FOMC remains months behind the proverbial risk curve in terms of ending extraordinary purchases of securities and will be in the midst of tightening policy even as the global economy heads into recession later this year. Leading the way into an economic slowdown will be housing, which benefitted enormously from QE but is now paying the price for the party via layoffs and a serious deterioration in operating profits.
US banks also must now struggle with rising funding costs and sluggish asset returns, reversing the benevolent environment when funding costs fell faster than asset-yields. As we note in The IRA Bank Book Q1 2022:
“We expect to see banks make progress in terms of building back interest income that was suppressed by QE, yet investors and risk managers need to be mindful that Q1 2019 is the real benchmark. The noise and adjustments to GAAP earnings during 2020 and much of 2021 make these years a throw-away analytically. If the Fed sticks to its guns and raises the target for federal funds a couple of percentage points during 2022, then residential mortgage rates will be at 5% by 2024 and the great mortgage correction of 2025 will be well in sight. Add to that picture the price inflation of war in Europe and 2022 becomes a year of growing credit risk.”
Besides the question of monetary policy and the economy, the key question facing the FOMC is when and how the extraordinary ease of the past several years will cause a serious correction in the affected markets, particularly stocks and real estate assets. Even a slowdown or cessation of double-digit price increases in these asset classes will present a serious challenge for investors and risk managers. But add the additional risk of unexpected credit losses and volatility will likely grow.
“There are currently two narratives - one focuses on a housing crash coming soon due to interest rate rises, and another on prices increasing in line with inflation,” Tim Thomas of the Wealth of Geeks Network wrote on Bloomberg this week. “Consequently, it's tough to know which conclusion individual investors will reach, and there's likely to be some diversity of opinion. Some may consider real estate a hedge against inflation, but others may get spooked and pull out, completely dampening demand further.”
Or as our friends at SitusAMC commented last week in a discussion of the market for mortgage servicing assets, sometimes as the risk free rate rises, the option-adjusted spread (OAS) goes down. To review, OAS is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, adjusted to take into account the embedded optionality. Given the volatility in terms of market risk and credit exposure flowing through the global economy, calculating OAS, let alone setting a coherent path for US interest rates going forward, will be a challenge indeed.
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