According to a recent estimate by Goldman Sachs, it might take the Federal Reserve approximately six more years to reduce its mortgage bondholdings to less than $1 trillion. Currently, the Fed’s balance sheet stands at around $8 trillion, down from its peak of nearly $9 trillion last year. However, progress in shedding its $2.5 trillion in mortgage-bond holdings has been sluggish, serving as a lasting reminder of its pandemic-era policies.
One major obstacle in this unwinding process has been the increase in U.S. mortgage rates, which now exceed 7%. With the Fed’s rate hikes, refinancing and sales activity have been largely put on hold. In fact, the Fed recently indicated that its policy rate could remain above 5% for an extended period, thereby further dimming the outlook for the housing market. This has raised concerns that mortgage rates could reach 8%, defying expectations of much-needed relief for Wall Street.
Emin Hajiyev, a senior economist at Insight Investment, highlighted the challenging conditions faced by new homebuyers. Even though many individuals have fixed-rate mortgages, affordability for prospective buyers has become strained. As 30-year mortgage rates soared from their pandemic low of 2.7%, Hajiyev estimated that home affordability has declined to its lowest level since at least 1989. He emphasized that, for the first time since 2006, the median income no longer qualifies for the median property available for sale.
Goldman Sachs has analyzed how the Fed’s presence has grown in the agency mortgage-bond market, which amounts to roughly $12 trillion since 2018. This analysis includes the significant increase in purchases made during the COVID crisis. However, the unwinding of these holdings has been slow. This year, the runoff of mortgage bonds has lagged behind the Fed’s monthly cap of $35 billion, averaging around $19 billion. It is important to note that the Fed is not actively selling bonds to reduce the size of its balance sheet; rather, it is allowing its holdings to mature.
Key Points:
- The Federal Reserve may take approximately six more years to reduce its mortgage bondholdings to less than $1 trillion, according to Goldman Sachs.
- The Fed’s balance sheet has decreased from around $9 trillion to approximately $8 trillion, with the unwinding process of its mortgage-bond holdings lagging behind.
- Climbing U.S. mortgage rates, due in part to the Fed’s rate hikes, have hindered refinancing and sales activity in the housing market.
- The Fed’s indication that its policy rate could remain above 5% for an extended period has provoked concerns that mortgage rates could reach 8%, contrary to expectations.
- New homebuyers are facing strained conditions, with declining affordability levels and the median income no longer qualifying for the median property available for sale.
- Goldman Sachs has analyzed the Fed’s growth in the agency mortgage-bond market since 2018 and identified a slow progress in unwinding its holdings. The runoff of mortgage bonds this year has fallen below the monthly cap set by the Fed.
- The Fed is not actively selling bonds to reduce its balance sheet size but rather allowing its holdings to mature.
The Implications of Runoff Caps on Financial Markets
The Federal Reserve’s caps on runoff have been implemented to prevent shocks in financial markets. As the Fed works towards achieving its yearly inflation target of 2% through higher rates and the unwinding of pandemic bond purchases, the focus now shifts to its mortgage-backed securities (MBS) portfolio.
Goldman Sachs credit analysts, led by Roger Ashworth, highlighted in a recent client note that the MBS portfolio is currently seeing a monthly runoff of approximately $19 billion. They anticipate that rate cuts in 2025 could increase this monthly runoff to around $25 billion, but it is expected to take until mid-2029 for the Fed’s mortgage-bond holdings to fall below $1 trillion.
While the Fed has announced that it will keep rates steady, it will continue reducing its securities holdings. However, an issue arises as mortgage bonds are highly sensitive to the Fed’s policy rate. According to Goldman analysts, the Fed’s mortgage bond portfolio has an average coupon of approximately 3.2%, serving as a proxy for interest rates. This makes it unlikely that $35 billion monthly paydowns will occur anytime soon.
Mortgages are typically priced at a premium in comparison to the risk-free Treasury rate. The recent significant increase in the benchmark 10-year Treasury yield, touching 4.51% on Monday (the highest since 2007), further emphasizes this point.
As for the stock market, Monday’s performance was mixed. The S&P 500 and Nasdaq Composite slightly increased after experiencing their largest weekly drops since the March banking crisis. On the other hand, the Dow Jones Industrial Average remained virtually unchanged and recovered from a small early loss.
Read next: Insight from the World’s Largest Asset Manager: Can the 10-Year Treasury Yield Continue Climbing from 16-Year Highs?
