Main Street Policy... Seriously?
By Jason Doiron
September 17, 2012
In case you did not catch the press conference last week, Ben Bernanke believes that his latest round of quantitative easing will benefit Main Street. Seriously? The notion that Main Street will benefit from the Fed purchasing an additional $40 billion per month of agency-backed MBS is preposterous to us.
Why? Because for the past four years, investors have accepted the fact that central bank headlines and liquidity have a greater impact on asset prices than underlying fundamentals. To use central banker parlance, the fundamental valuation transmission mechanism has experienced a transitory interruption. The market has accepted this interruption and successful investors have found a way to ascertain the relevant facts and base their investment decisions on these. For successful investors, relevant facts drive the investment decision-making process. The same cannot be said for central bankers.
At Sentinel, our natural curiosity as investors leads us to ignore the Fed's story and focus on the facts. Bernanke provided the economic rationale for how the transmission mechanism works but the facts do not validate the story. Looking at the last three rounds of quantitative easing (QE2, Twist 1, and Twist 2) we see that 30-year mortgage rates were actually higher 60 days after the announcement by an average of 24.3bps.
The magnitude of the move may not be material but the fact that mortgage rates moved in the unintended direction makes us believe there is an error with either the rationale or the transition mechanism. Given this lack of factual support to the Fed's story, we thought it would be interesting to explore some of the additional intended and unintended consequences of the latest round of quantitative easing.
As bond investors, we find the unintended consequences of the Fed's actions on the MBS market most troubling. The Fed is already the dominant player in the agency-backed MBS market with $844 billion in holdings. They currently consume $25 - $30 billion of MBS per month through reinvesting the principal payments from current holdings. Starting immediately, the Fed will consume an additional $40 billion of MBS per month (open-ended) bringing the total amount to $65 - $70 billion per month.
To put this amount in context, the agency-backed MBS market issues roughly $135 billion of debt per month. Of this amount, our desk estimates that $35 - $40 billion is retained by MBS servicers / originators and therefore not available to investors. That leaves roughly $95 billion per month for investors. The Fed intends to purchase $70 billion per month or almost 75% of that available supply.
|$135 billion||Monthly supply of agency-backed MBS|
|- $35 to $40 billion||Retained by servicers|
|- $25 to $30 billion||Fed principal reinvestment activity|
|- $40 billion||QE3 open-ended purchases|
|$25 - $35 billion||Supply remaining for investors|
There are always and everywhere unintended consequences when a government entity consumes 75% of the supply of a functioning asset class. Agency-backed MBS play a critical role in fixed income portfolio construction. As an asset class, MBS provides us with an income producing, low volatility building block. We consider agency-backed MBS the dominant volatility anchor in a complex fixed income portfolio. It is the asset class that allows fixed income investors to take additional, perhaps uncorrelated risks in other markets such as high yield and CMBS. The Fed's actions have the potential to force investors into less effective alternatives to source this low volatility building block.
The Fed would really prefer to just buy treasuries but at this point, the Fed cannot expand its balance sheet with outright treasury purchases. Why? Because it is reaching the saturation point where additional purchases would simply monetize the debt. By purchasing 75% of the available supply of agency-backed MBS, the Fed is forcing traditional buyers of that asset class into substitutes. Given the size, liquidity, credit risk profile, and negligible capital charge for agency-backed MBS, there is only one substitute...US treasuries! With an open-ended commitment to purchase agency-backed MBS, the Fed will force other investors to do its dirty work for it and buy treasuries.
Bottom Line: Throughout the earlier rounds of quantitative easing, we have been very active in explaining to our clients why they should not be concerned about inflation. Given this latest round of open-ended quantitative easing, we no longer have a sanguine view on inflationary pressures in the US. To us, there is clearly an issue with the transmission mechanism that the Fed is too quick to dismiss. The Fed has been so concerned with the accelerator that it has not tapped the brakes to see if they still work. More discussion to follow on this topic.
Sources: Securities Industry and Financial Markets Association, Sentinel Asset Management, Inc.
(c) Sentinel Investments