"What just occurred [in the mortgage-backed-securities (MBS) market] is indicative of just how important QE is," as government backed US mortgage bonds suffer their largest quarterly decline in almost two decades. As Bloomberg reports, the $5 trillion market lost 2% in Q2, the most since the 'bond market massacre' in 1994 (when the Fed unexpectedly raised rates) as wholesale mortgage rates spiked by the most on record in the last two months. The reason these bonds have been hardest hit - simple - fear that the Fed's buying program is moving closer to an end. "The Fed, at times during this period, was the only outlet in terms of demand for securities," explains one head-trader, as the Fed’s current buying provided demand as other investors retreated and has grown as a percentage of forward sales by originators tied to new issuance, which is set to fall as higher rates reduce refinancing. With Fed heads talking back what Bernanke hinted at, there was a modest recovery in the last 2 days in MBS but the potential vicious cycle remains a fear especially now that “what was once deemed QE Infinity is no longer viewed that way."
Government-backed U.S. mortgage bonds are poised for their largest quarterly loss in almost two decades, with some of the debt extending declines today.
“What just occurred is indicative of just how important QE is,” Brad Scott, Bank of America’s New York-based head trader of pass-through agency mortgage securities, said today in a telephone interview.
The Fed’s current buying provided demand as other investors retreated and has grown as a percentage of forward sales by originators tied to new issuance, which is set to fall as higher rates reduce refinancing, according to Scott.
“The Fed, at times during this period, was the only outlet in terms of demand for securities,” he said.
The mortgage-bond losses rival the 2.3 percent declines in the first quarter of 1994 amid a slump in debt prices sparked by the Fed unexpectedly raising its target for short-term interest rates on Feb. 4 of that year, the first of seven increases totaling 3 percentage points. Fortune magazine at the time declared it a “bond market massacre.”
Home-loan debt without government backing has also been damaged. Subprime-mortgage securities have lost about 2 percent this quarter, including a 4.9 percent drop this month, according to Barclays Plc index data.
The plunge in mortgage-bond prices has sent borrowing costs soaring to the highest since July 2011. The average rate for a 30-year fixed mortgage rose this week to 4.46 percent from 3.93 percent, the biggest one-week increase since 1987, according to Freddie Mac surveys.
The underperformance is tied partly to the way in which the lifespan of mortgage securities extends as projected refinancing declines, as well as the potential slowing of the Fed’s buying in the market.
The rout has been exacerbated by sales by real-estate investment trusts and other firms that rely on borrowed money that are seeking to pare rising leverage ratios, as well as adjustments tied to changes in the expected lives of the debt, a dynamic known as convexity, according to analysts from Credit Suisse Group AG to JPMorgan Chase & Co.
Now, Fidelity’s Irving said, “what was once deemed QE Infinity is no longer viewed that way.”
It seems that just as the NYFed attempts brief reverse repo open market operations to judge the market's 'tightness', this was an exercise in judging the market's ability to withstand any monetary free-money support... and it certainly sent a loud and clear message to the Fed.