FLASH UPDATE: Porfiting from the impending decline in Fed's Agency MBS Buying

As Treasuries begin to refocus on the Fed’s initiation of policy tightening, it is prudent to also consider the effects of the inevitable deceleration in its MBS reinvestment program.  While the Fed has already stopped its QE3 purchases of $40 billion per month in AGY MBS, they are still currently reinvesting principal and interest payments from their MBS portfolio into new securities.  The reinvestment program results in $20 to $30 billion in monthly MBS purchases.  While our expectation is that the Fed will not liquidate their portfolio of AGY MBS, we expect them to transition towards run-off mode by ceasing to reinvest payments of principal and interest.

Shorting the basis is one of the trades we are eyeing as part of our AGY MBS relative value trading strategy.  We anticipate that over time the basis will revert towards pre-crisis levels as the Fed, who is currently by far the largest single buyer of MBS, exits the market as part of a reduction in quantitative easing.  Our view is that the Fed’s exit is not yet priced in and we examine an opportunity to earn outsized returns using a tactical short that will benefit from a retracement. 

At present, the AGY MBS basis sits near historically tight levels due to the influence of many supportive factors (Fed purchases, limited available float, low rate volatility, tight credit conditions/benign issuance). These factors are reversing course and will push the basis wider.  While higher regulatory hurdles have impeded loan origination over the last few years, rising interest rates will begin to serve as an incentive for banks to increase their lending activities.  The combination of increasing supply, reduced Fed buying, and rising volatility should put pressure on mortgage spreads.     

The spread between AGY MBS and Treasuries, which currently sits near 75bps, is markedly tighter than its pre-crisis average of 125bps. The chart below illustrates the trade’s expected return assuming the spread retraces 50% of the gap.  For perspective, this 25 basis point move would be smaller in magnitude and could occur in a like timeframe as the 35bp widening experienced over a six-week period during the summer 2013 taper tantrum. 

Please contact us if you would like to hear more about our view on this trade thesis or our other thematic ideas.

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global