Fed QE3 in mortgages limited to half size of QE1, Barclays says

June 18, 2012 09:30 AM
Odds for more QE at 60%

June 18 (Bloomberg) -- Any new buying of government-backed mortgage bonds by the Federal Reserve will be limited to no more than $500 billion to $600 billion per year by supply constraints, according to Barclays Plc.

That would be less than half the amount purchased in the first round of the Fed’s so-called quantitative easing. During QE1, the central bank bought $1.25 trillion of mortgage-backed securities from January 2009 through March 2010 in a bid to stabilize housing and financial markets.

“The agency MBS market might have more trouble accommodating the Federal Reserve this time,” Barclays analysts including Nicholas Strand, Siddarth Ramkumar and Sandipan Deb wrote June 15 in a weekly report. The Fed would seek to avoid creating market “dislocations” through its buying, a dynamic that may lead it to include Treasuries in QE3, they said.

Signs of faltering growth amid European debt turmoil, combined with inflation below the central bank’s 2 percent target, mean the Fed will announce new steps to boost the economy as soon as a meeting this week, according to 12 of the 21 primary dealers who trade with the central bank. Barclays says it’s a “close call” on whether the Fed will introduce additional easing this month, at roughly 60 percent odds.

The most likely easing at the meeting would be an extension of the Fed’s Operation Twist program, in which it’s been selling shorter-maturity Treasuries to buy longer-term ones, according to Barclays. The central bank may create a modified Twist operation of $350 billion to $400 billion through the addition of sales of Treasuries maturing in as much as four years, which could also include mortgage buying. QE3, which is less likely, probably would focus on home-loan securities, Barclays said.

Net Issuance

During QE1, supply entering the more than $5 trillion agency mortgage-bond market totaled about $511 billion, as a result of Fannie Mae and Freddie Mac shrinking their balance sheets, sales by overseas investors and net issuance, the New York-based Barclays analysts estimated in their report.

Over the next 12 months, supply could total $170 billion as the market’s growth has slowed, with $108 billion of net issuance expected, down from $396 billion during QE1, they said.

The Fed, which already owns about $850 billion of the securities, started reinvesting in the market in October with proceeds of its past purchase of housing-related debt. Agency mortgage securities carry guarantees from taxpayer-supported Fannie Mae and Freddie Mac or government-owned Ginnie Mae.

Many MBS investors cannot switch to “lower-credit assets,” making them unlikely to sell, the analysts said. During QE1, the Fed took assets coming off the books of money managers, insurers and pension funds, either through sales or repayments, they said.

Riskier Investments

While pushing bond buyers into riskier investments is “likely one of the Fed’s intended effects,” many mortgage-bond holders would need “significantly tighter MBS spreads” before selling, the Barclays analysts said.

Money managers are constrained by the greater amount of “top-credit securities” in the benchmark bond indexes that they intend to track or beat, as a result of the expansion of the Treasury market, they wrote.

At the same time, U.S. banks purchase agency mortgage securities for “capital and liquidity reasons” while real estate investment trusts must focus on property-related assets, they said. Commercial-bank holdings swelled to almost $1.34 trillion this month from about $950 billion at the start of 2009, while REITs’ portfolios climbed to $237 billion at the end of 2011, from about $90 billion, Fed data show.

“Most major overseas investors” are unlikely to want to invest much of their dollar reserves in anything but government- backed securities, the Barclays analysts said.

“Given these investor constraints and lower natural supply, we would expect a little Fed involvement to go a long way to tightening spreads,” they said. If the central bank doesn’t announce QE3 this week, the mortgage market shouldn’t be damaged too much because the option will remain for later, they added.

Bloomberg News

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