Fed’s balance sheet
The Fed refers to rate liftoff as “rate normalization.” Having interest rates at the zero mark for an extended period is causing distortions in the credit markets. It’s putting pressure on pension funds and insurance companies that need to earn a safe and sizable return on their assets to meet their future liabilities. The actuarial tables could care less if interest rates are at zero.
Fed’s balance sheet is huge
QE (quantitative easing) increased the size of the Fed’s balance sheet almost eightfold since the turn of the century. The Fed’s balance sheet had just over $500 billion in assets in 2000. Currently, it holds around $4.5 trillion.
In 2014, FOMC members examined the possibility of beginning to unwind the Fed’s portfolio of Treasuries and MBS (mortgage-backed securities). Those discussions don’t appear to have gone any further.
At the July 2016 meeting, the Fed decided to continue to reinvest maturing proceeds back into the Treasury and MBS market. The Fed anticipates continuing this policy until the “normalization of the level of the federal funds rate is well under way.” Given the lofty levels of bonds and MBS at the moment, this does open the Fed up to capital losses if rates reverse. Ironically, the Fed’s policy action—attempting to increase inflation—will cause it to have capital losses if it’s successful. Ultimately, it doesn’t make sense to view the Fed as motivated by profit like a typical bond investor. The Fed is motivated by social goals—not whether it makes money on its bond portfolio. If it were a typical bond investor, it would probably be selling Treasuries (or at least monitoring for when to hit the exits) because they’re priced as if inflation is never coming back.
The Fed had been worried that it may not be able to work the normal levers of monetary policy with its huge balance sheet. As we saw in the federal funds rate, the Fed was able to move the target rate effectively despite the huge balance sheet.
Impact on mortgage REITs
Currently, the Fed’s decision to reinvest QE assets in markets impacts REITs in two ways. First, it keeps a bid under TBA (to-be-announced) MBS—mortgage rates are being pushed down. This helps originators such as Nationstar Mortgage Holdings (NSM) and Wells Fargo (WFC).
Second, the Fed’s decision to reinvest QE assets in the market supports MBS values in general. If the Fed decides to start selling its portfolio, it could cause turbulence in the bond markets. This would have a negative impact on 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 can look at the S&P SPDR Financials ETF (XLF). Investors interested in making directional bets on interest rates can consider the iShares 20+ Year Treasury Bond ETF (TLT).