Yahoo Finance The FOMC Decides to Maintain Its Balance Sheet at $4.5 Trillion
A June Rate Hike Is Back in the Cards: The April FOMC Minutes
The state of the 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 also 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 couldn’t care less if interest rates are at zero.
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 had just over $500 billion in assets in 2000. Currently, it holds around $4.5 trillion.
In 2014, the 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 April 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.
Ultimately, it doesn’t make sense to view the Fed as motivated by profit the way a typical bond investor is. The Fed is motivated by social goals and not whether it makes money on its bond portfolio. If it were a typical bond investor, it would probably be selling Treasuries, as they are priced as if inflation is never coming back.
The risk to the mortgage-backed securities market is that there might not be enough demand for new MBS without the Fed stepping in to buy paper. This could cause mortgage rates to spike if the Fed backs away.
Effects on mortgage REITs
At the moment, the Fed’s decision to reinvest QE assets in the markets affects REITs in two ways. First, it keeps a bid under TBAs (to-be-announced MBS), meaning that 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 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 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).
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