It’s clear why the bond market sold off
For market participants who were hoping that the September decision to keep asset purchases “as is” meant that QE (quantitative easing) would continue for the foreseeable future (in other words, QE4EVA) were disappointed. Many believed that a December taper was more or less out of the question based on the shutdown. The language regarding the effects of the shutdown—”limited and temporary”—combined with the stronger-than-expected October jobs report and retail sales this morning, means that we’re again looking at a distinct possibility of a December taper and an almost certain March taper.
In terms of the footprint in the markets, it makes sense for the Fed to taper anyway, even in the absence of better employment data. Why? The end of the refinance boom. MBS (mortgage-backed securities) issuance has been declining since summer as refinance activity has fallen off a cliff. Take a gander at the MBA refinance activity index above. It fell by 70% peak-to-trough ever since rates started going up. When you consider that 64% of the mortgage market is refinance activity, that is a big drop. What that means is that the Fed’s $40 billion a month of MBS purchases is a lot more significant (because it is a larger percentage of MBS issuance) than it was last spring. In other words, by doing nothing, the Fed is actually increasing its footprint. For that reason alone, the Fed should consider reducing MBS purchases.
Implications for the mortgage REITs
We’ve seen MBS spreads to Treasuries tighten over the past few months, presumably due to the Fed’s increased footprint. The REITs like Annaly (NLY), American Capital Agency (AGNC), MFA Financial (MFA), Hatteras (HTS) and Capstead (CMO) could get hit with a double-whammy when the Fed begins to taper—the ten-year will drop in price and MBS spreads to Treasuries could widen. This would mean its book values take another hit. That said, pretty much everyone has de-leveraged in a big way since rates started going up. Any further increases in interest rates will have less of an effect than they did during the second quarter when the entire sector got taken out to the woodshed. For the REITs, the temporary reprieve is probably over.