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, which will create 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. Policymakers 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. The Fed’s balance sheet held just over $500 billion in assets in 2000. Currently, it’s around $4.5 trillion.
In 2014, the FOMC (Federal Open Market Committee) members examined the possibility of beginning to unwind its portfolio of Treasuries and MBS (mortgage-backed securities). Those discussions don’t appear to have gone any further.
At the September 2015 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 in two ways. First, it keeps a bid under TBAs (to-be-announced mortgage-backed securities), which means that mortgage rates are being pushed down. This helps originators such as Nationstar (NSM) and Wells Fargo (WFC).
Second, it supports MBS 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), and MFA Financial (MFA).
Investors interested in trading in the real estate sector should look at the S&P SPDR Financials ETF (XLF). Investors interested in making directional bets on interest rates should look at the iShares 20-Year Bond Fund (TLT).