The fed’s asset purchase program, also know as quantitative easing (QE) has swelled the Fed’s balance sheet from under $1 trillion pre-crisis to an all-time high of $3.2 trillion. The Fed has pursued this strategy in order to drive down long-term interest rates. The Fed is able to set rates at the short end of the yield curve directly by setting a target rate for the Federal Funds rate. However, they have historically been powerless to determine long term rates. Quantitative easing was the Fed’s answer to “What else can we do once interest rates are zero?”
In response to the crisis, the Fed first lowered short term interest rates, and then conducted “Operation Twist,” which was its first attempt to lower long-term interest rates. The Fed would sell its short-term Treasury notes and purchase longer dated Treasuries with the proceeds. The idea was that the Fed could maintain the same net financial exposure, while at at the same time push down longer term interest rates. After deciding that more needed to be done, the Fed pursued quantitative easing, by purchasing Treasuries and Mortgage Backed securities directly for its own balance sheet.
How will the Fed unwind the trade?
Quantitative easing has had a beneficial affect on the Fed’s balance sheet – as they push down interest rates, the value of the bonds on their balance sheet increase. In fact the Fed had a profit of $89 billion in 2012, which it paid to Treasury. The Fed’s P/L is a line item in the US budget. The Fed’s assets are largely long-term Treasuries and mortgage backed securities; its liabilities are federal reserve notes, or the actual currency in your wallet. They pay no interest on these liabilities, so they make a decent financing spread and the value of their assets have been increasing due to their own buying.
The big question relates to how the Fed unwinds the trade. It even has a name – Fexit – short for Fed Exit. The Fed currently owns about 70% of US Treasuries and has been buying most of the mortgage backed securities being issued. In its last Federal Open Market Committee (FOMC) minutes, the Fed polled primary dealers and asked them when they thought the Fed would end QE. Most seemed to settle on Q114. Of course if the Fed stops buying, interest rates will undoubtedly increase. And the private markets will probably have a tough time taking on all the paper the Fed wants to sell. The Fed will probably be forced to let these bonds mature and not sell them.
Implications for mortgage REITs
Any sort of unwinding of QE will precede an increase in short term rates. If long-term rates rise, while short term rates stay the same, the yield curve steepens. A steepening yield curve is a double edged sword for mortgage REITs like American Capital (AGNC), Annaly (NLY), or Hatteras (HTS). On one hand, as yields increase, it means that the price of their assets is falling, which gives them mark-to-market losses. On the other hand, it means that their interest margins are increasing, which helps their profitability. Increases in long-term rates will certainly lower prepayments, and REITs could be in a great position if long term rates slowly rise, and short-term rates stay the same. Once short term rates start increasing, they will face higher funding costs which will compress margins.
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