Might the Federal Reserve Purchase More Agency MBS?

Plain and Simple: YES. If open market asset purchases push benchmark yields and mortgage rates lower, to the point where loan refinancing increases enough to rapidly reduce the Fed's MBS portfolio holdings, then they might need to buy more agency MBS.

The proof needed to make that claim can be found in Ben Bernanke's prepared remarks at Jackson Hole Wyoming, titled The Economic Outlook and Monetary Policy given on August 27, 2010, right before mortgage rates rallied to new record lows.

Excerpts from Ben's Speech...

The channels through which the Fed's purchases affect longer-term interest rates and financial conditions more generally have been subject to debate. I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve's purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public

Specifically, the Fed's strategy relies on the presumption that different financial assets are not perfect substitutes in investors' portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.

At their most recent meeting, FOMC participants observed that allowing the Federal Reserve's balance sheet to shrink in this way at a time when the outlook had weakened somewhat was inconsistent with the Committee's intention to provide the monetary accommodation necessary to support the recovery. Moreover, a bad dynamic could come into at play: Any further weakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed's balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening--a perverse outcome.

We decided to reinvest in Treasury securities rather than agency securities because the Federal Reserve already owns a very large share of available agency securities, suggesting that reinvestment in Treasury securities might be more effective in reducing longer-term interest rates and improving financial conditions with less chance of adverse effects on market functioning. Also, as I already noted, reinvestment in Treasury securities is more consistent with the Committee's longer-term objective of a portfolio made up principally of Treasury securities. We do not rule out changing the reinvestment strategy if circumstances warrant, however.

FURTHERMORE...

From NY Fed's Brian Sack in a speech titled, Managing the Federal Reserve's Balance Sheet , given on October 4, 2010

"If the market were to begin having trouble digesting that prepayment risk, the spread between MBS rates and Treasury yields could widen. A significant widening of MBS spreads to Treasuries, whether due to this or other factors, could affect policymakers’ decisions about which assets to purchase. The Chairman’s speech in Jackson Hole and the August FOMC minutes both indicated that reinvesting in MBS rather than Treasury securities might become desirable if market conditions were to change."

Plain and Simple: These statement set the stage for QEII.  Ben is explaining one methods how he intends to empoy to reflate the monetary base...by soaking up a specific asset class and forcing investors further out the credit curve. Hopefully this will lead to another explosion in corporate debt issuance which will allow businesses to invest in themselves at cheaper funding costs which should then spark hiring or lead to wage growth. We gotta get more money in the hands of the folks who still have jobs.  That seems like the most efficient strategy at the moment (yikes what does that say about the lower half of the middle class. Gone?)

re: MBS prepays and mortgage rates

Ben is telling us that more MBS purchases are possible if we experience another mini-refi boom after the Fed announces QEII. Anyone remember who was the most prominent buyer of agency MBS between January 2009 and March 2010? The Federal Reserve! During this period, anyone who could refinance, probably already pulled the trigger, but that doesn't mean they won't do it again. The fact that Ben is indicating this might become a "problem" is another hint that mortgage rates should touch record lows again sometime soon after a QEII announcement is made on Wednesday.