Market Memo: Why housing is getting better (but the mortgage securities side isn't)
There’s little doubt that, from an economic growth standpoint, the housing market is steadily improving. Consumers are benefitting from rising home and stock prices, which have propelled household net worth to record highs. The subsequent improvement in household balance sheets, combined with still near-record high housing affordability, is helping drive new-home starts and sales.
To be sure, headwinds remain. Consumers remain cautious about adding mortgage debt, loan underwriting guidelines are stringent and student loans are taking a larger bite out of incomes. But the overall prognosis is one of improvement. While residential construction is roughly half its 2006 peak, housing is on an upward trend, and its contribution to GDP is growing. Home-builder stocks also have rebounded in recent months, reflecting the improved outlook.
But from a mortgage-backed securities (MBS) perspective, it is necessary to separate the housing economy from the Fed-dominated world of mortgage investment. And on that front, the view isn’t nearly as upbeat. Under quantitative easing, whose main goal is interest-rate suppression in an attempt to reduce corporate and consumer finance costs and thus support economic expansion and job creation, the Federal Reserve’s balance sheet has ballooned to more than $4.1 trillion, comprised mainly of Treasury and MBS. As the dominant buyer of agency MBS, the Fed has succeeded in reducing mortgage rates and MBS yields.
Fed’s dominance skews MBS opportunities
So what is the market impact now that the largest buyer of MBS begins to taper its purchases of the security and ultimately ceases investment? That is the million dollar question! Overseas investors, banks, real estate investment trusts (REITs) and money managers were sellers of MBS over the course of 2013, but that supply—and a lot more—was soaked up by the Fed, which does not utilize a relative value or total return framework in making investment decisions. Ultra-accommodative policy goals far outweigh such traditional considerations.
Where does that leave our MBS outlook? Let’s start with what we know. We know MBS yields are low relative to the range that existed prior to the Fed’s launching of QE five years ago, so the risk/reward framework is less attractive after nearly $1.6 trillion of Fed purchases. And MBS do not appear inexpensive relative to alternative fixed-income assets, so crossover buying potential seems limited. While it remains to be seen whether valuations will return to “normal” historical ranges, it’s our best guess that some level of greater compensation will be required to entice total return investors post-Fed.
Traditionally, positive economic development in a given sector correlates with performance of associated investment instruments. We can see that with the fortunes of home builders and housing activity. But can a similar connection be made between housing and an MBS world dominated by Fed QE? Maybe not so much.