Fed’s Mortgage Holdings May Dampen Future Bond Sell-Offs, Fed Says

If yields rise, chances for the rapid increases in rates are fewer because the Fed isn’t inclined to hedge its $1.6 trillion in mortgage bonds against rising rates, the New York Fed economists said. Leaving the Fed portfolio with no hedges, or “infrequently” hedged, reduces the type of trading that is often blamed for exacerbating bond selling, they said.

Mortgage bond hedges, which in times of falling rates include purchases of Treasury securities, are typically unwound when rates rise, causing yields to increase further. The cycle can repeat itself, as it did in 1994 and 2003 when 10-year Treasury yields rose about 2.5 percentage points and 1.5 percentage points, respectively, the economists said.

When mortgage rates fall, some investors buy Treasurys because more homeowners will refinance and prepay their loans, depriving mortgage bond investors of securities with higher income. Rising mortgage rates cut refinancing, extending the time that investors will receive below-market returns.

The Fed’s decision not to hedge its mortgage bonds has a greater impact as its influence over the $5.4 trillion “agency” MBS market has grown, the economists said.

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