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U.S. mortgage-backed securities have broadly performed well as the Fed began its balance sheet normalization process. Nominally smaller reinvestment amounts have not rattled MBS performance, and MBS have managed modest outperformance over Treasuries since September. Performance has been well in line with prior Fed tightening campaigns despite the additional influence of diminished reinvestment.
Comment
The Fed began tapering its reinvestment of mortgage-backed securities in October as part of its balance sheet normalization plan. The Fed, of course, has made no sudden movements with normalization. The small initial amount withheld from reinvestment, the gradual decrease in reinvestments and the well-telegraphed plan were all intended to minimize market reaction. Still, as we discussed in our September conference call, the Fed appeared to have little margin for error.
So far, the efforts to avoid disruptions have been a success. The Bloomberg Barclays U.S. MBS Index outperformed the U.S. Treasury index in September and widened that performance gap into year-end. The chart below shows total returns for the Bloomberg Barclays U.S. mortgage-backed securities and U.S. Treasury indices since 2016.
U.S. MBS have outperformed Treasuries by 1.15% since 2016 with essentially all of this outperformance materializing since the September confirmation of normalization.
Despite the additional pressures from reduced Fed reinvestment purchases, the performance of mortgage-backed securities relative to Treasuries has been very consistent with prior tightening cycles. The next chart shows the spread between total returns for the U.S. MBS Index and U.S. 10-year note. Mortgage-backed securities outperformed 10-years by 4.6%, 2.0%, and 1.9% in the prior three cycles, well in line with the current 2.6% margin. Historically, MBS performance has stalled toward the end of tightening cycles as markets priced in a more stable policy environment.
What happens after tightening cycles come to an end? Mortgage-backed securities performance appears to follow a consistent pattern during periods where the Fed is on hold. The next chart shows the spread between the Bloomberg Barclay’s U.S. MBS index and U.S. 10-year note total returns in the period after the Fed first held rates at the end of a tightening cycle. MBS have performed roughly in line with 10-years in the first few months after the Fed stops tightening. But performance quickly sours with MBS tending to underperform 10-years as it becomes clear the Fed may need to begin easing.
Now any switch to a neutral policy stance from the Fed is still well off. As we have highlighted, U.S. economic performance has been remarkably strong in the closing months of 2017. The Fed has stuck to its message of three additional tightening moves in 2018, even though markets expect less. With any shift toward expectations for falling policy rates, the door for MBS outperformance is still open.
As the next chart shows, mortgage-backed securities have maintained a superior reward-to-risk ratio over Treasuries since 2010. The chart shows 1-year averages of daily returns divided by the standard deviation of daily returns over that period. Here again, we use the Bloomberg Barclays U.S. MBS and U.S. Treasury total return indices.
The higher reward-to-risk ratio is a function of lower volatility for MBS total returns. The biggest risk for MBS investors is that the volatility premium disappears. Note that the two recent instances where this lower volatility broke down were periods of sharply rising Treasury yields in mid-2013 and following the November 2016 presidential election.
The scatter plot below shows 66-day total returns for the Bloomberg Barclays Treasury index on the x-axis and for the U.S. MBS index on the y-axis. The volatility of MBS returns rises as Treasuries see total return losses in a quarter exceed 2%. The polynomial trendline also dips down at this point, indicating that MBS total returns have a tendency to fall faster, underperforming Treasuries.
Conclusions
U.S. mortgage-backed securities have weathered the first months of the Fed’s balance sheet normalization and even outperformed Treasuries since the tapered reinvestment policy was confirmed. The near-term outlook for MBS performance relative to Treasuries looks balanced, if not favorable. The biggest risk for the low volatility advantage for MBS is a sharp rise in Treasury yields.