The significant turmoil seen in financial markets over the past couple of weeks has led some investors to use the U.S. mortgage market as a source of liquidity, pushing valuations down to levels that have brought back memories of 2008. The recent dislocation is one of the most rapid and severe we’ve seen – and this is all with the backdrop that there are no solvency concerns around the mortgage agencies, Fannie Mae and Freddie Mac, in contrast to the experience during the financial crisis.
We believe the volatility in the mortgage market is creating pressure in the financial system, but at its core, this is a liquidity-driven dislocation and that type of dislocation is one the Federal Reserve is well-equipped to address.
Indeed, the Fed has acted rapidly with supportive measures: 150 basis points (bps) of rate cuts, additional quantitative easing (QE) of $500 billion worth of Treasury purchases and $200 billion worth of agency mortgage-backed securities (MBS) purchases, and an end to the central bank’s tapering program (i.e., halting reduction of its balance sheet, still full of the mortgages it bought as part of its QE programs aimed at supporting the housing sector and the economy). While these moves have been necessary to date, they have not been sufficient to curtail the continued volatility we see in mortgage markets.
We believe the Fed’s moves, as well as future ones, will over time be supportive of the mortgage asset class for two reasons:
- Reduced pressure to sell: Pressured by rapidly falling equity prices, leveraged investors have rushed to the mortgage market seeking liquidity in an environment that is not nearly as liquid as it normally is. Support from the Federal Reserve for agency MBS should reduce some of the forced liquidations from these sellers, supporting mortgage prices.
- Better supply/demand dynamics: Increased supply of mortgages, due to the lower refinancing rates, has been pressuring the mortgage market, and so did the Fed’s unwinding of its balance sheet. However, we estimate the Fed’s stop to its tapering program to turn it from a net seller of $240 billion per year to now a net buyer of $200 billion – a $440 billion swing that should support mortgage prices.
We believe the Fed and the U.S. Treasury’s efforts to improve overall market liquidity will have a positive effect on mortgage pricing, bringing opportunity to investors. At present, we see value in assets trading at what appear to be historically cheap valuations.
These assets include agency MBS, which are trading at levels seen during the financial crisis despite their U.S. government or agency backings. The asset class also benefits from having direct Fed intervention, improving carry, and the highest mortgage rates in nine months, which should reduce prepayment risk. These characteristics, plus what we believe are attractive valuations, bring some of the best technicals that we have seen in the asset class in years. Going forward, we believe we should continue to see an improvement in mortgage spreads moving back to fair value.
Mortgage market analysis, not an economic view
Adding to mortgages, however, is not taking a view on whether or when the economy and growth will recover. At PIMCO, we assess opportunities on the basis of the compensation received for the risk taken, relative to history, which in the case of agency MBS, and at present, is highly attractive in our view.
However, it will take time for the mortgage market to return to more normal valuations as the impact of the Fed’s actions will take time to flow through the market and materialize. We may not have seen the end of this volatile period yet, but given the positive fundamentals, the improved technicals, the better financing possibilities following the liquidity injections in the repo market, and the central bank and government support, we believe that at present mortgages present one of the most compelling investment opportunities available in high quality fixed income markets.
For more on the potential benefits of the Fed’s move to maintain MBS on its balance sheet, read “The Fed Has Another Lever to Pull”
Please see PIMCO’s “Investing in Uncertain Markets” page for our latest insights into market volatility and the implications for the economy and investors.
Dan Hyman is PIMCO’s head of agency MBS portfolio management and a regular contributor to the PIMCO Blog. Ryan Murphy is a fixed income strategist focusing on PIMCO’s mortgage and credit strategies.