The state of the Fed’s balance sheet
The “elephant in the room” at the Fed is that rates need to return to more normal historical levels at some point. This will be in the context of a massive Fed balance sheet. This creates issues on many different levels.
The Fed also noted that we’re more or less in uncharted territory. While the Fed doesn’t anticipate increasing rates anytime soon, it’s starting to figure out which monetary levers will be most effective. The Fed staff will continue to research this question.
The Fed’s balance sheet has gotten huge
Quantitative easing (or QE) has increased the size of the Fed’s balance sheet almost eightfold since the turn of the century. From holding just over $500 billion in assets in 2000, it passed $4 trillion at the end of last year.
Earlier in the year, the FOMC (Federal Open Market Committee) staff examined the possibility of beginning to unwind its portfolio of Treasuries and MBS. Those discussions do not appear to have been taken any further. At the December meeting, the Fed decided to continue to reinvest maturing proceeds back into the Treasury and MBS market. Given the lofty levels of bonds and MBS at the moment, this does open the Fed up to capital losses if rates reverse.
Effects on mortgage REITs
At the moment, the Fed’s decision to not sell and to reinvest QE assets in the markets affects REITs two ways. First, it keeps a bid under TBAs (technical bid analyses), which means that mortgage rates are being pushed down. This helps originators such as PennyMac (PMT) and Redwood Trust (RWT). Second, it supports MBS (mortgage-backed security) values in general. If the Fed decides to start selling its portfolio, it could cause turbulence in the bond markets. This will negatively affect mortgage REITs such as Annaly Capital Management (NLY), American Capital Agency (AGNC), Capstead Mortgage (CMO), Hatteras Financial (HTS), and CYS Investments (CYS).