Agency MBS key questions for 2024

The post-COVID period has been a volatile one in agency mortgage-backed securities (MBS), with the Bloomberg Agency MBS Index recording both some of its best and worst months in history. Agency MBS current coupon bond spreads reached their widest levels since the global financial crisis (GFC) at ~180 basis points (bps) in 2023 before tightening rapidly — along with other risk assets — to close the year at ~140 bps. As we think about agency MBS for the coming year, we see significant value even after this tightening given the attractive valuations relative to history, supported by improving technicals and strong fundamentals.

With that in mind, we wanted to share our thoughts on eight key questions for the agency MBS sector as we look forward into 2024.

1. What impact will the eventual start of the Federal Reserve’s (Fed’s) rate cutting cycle have on mortgages?
   We believe a measured cutting cycle can be a positive tailwind for mortgages. There is a little over US$6 trillion in money market assets today given the attractive yields from elevated front-end rates. This is likely to change as we move through the rate cutting cycle and see a steeper (or at least less inverted) curve. We believe a portion of these assets may shift to fixed income instruments with longer durations to improve total return potential. Agency MBS, being a large part of traditional fixed income benchmarks, is likely to benefit from that. 
2. What is the path and potential impact of the Fed’s quantitative tightening (QT) program?
   The Fed’s absence from the agency MBS market has been a significant headwind for the sector over the past several years. The uncertainty of the Fed’s future path has limited security purchases from banks, in addition to creating an overhang on potential outright mortgage sales by the Fed. However, the worst may be behind us. The December 2023 FOMC meeting minutes combined with discussions from Fed officials lead us to believe that the end of QT is getting closer. This would support banks' ability to maintain deposits, even if Fed reinvestments are in T-bills or T-bonds. Stability in bank reserves could encourage banks to increase their securities portfolios in an environment where loan growth remains low. 
3. How likely are banks to be a meaningful buyer of MBS over the next 6 – 12 months?
   In an environment where the Fed starts cutting rates, banks would earn less from their reserves at the Fed as short-term yields fall, which may be a catalyst for banks to buy securities to protect their net interest margins. Additionally, the new banking regulations (referred to as “Basel III endgame”) continue to make MBS look attractive versus other sectors on a risk-weighted basis and may generate a renewed appetite for agency MBS from banks over time. We think this demand may be particularly strong in GNMAs given their favorable risk capital treatment. Bank appetite will not be uniform, however, as smaller banks struggling with balance-sheet pressures will have less room to add.
4. How responsive will borrowers be to refinance their mortgages?
   Materially lower rates during late-2023 drove 30-year primary mortgage rates lower by ~1.3% to near 6.5%, resulting in an increase in prepayment activity for higher coupon mortgages such as 6.5% – 7.0%. Prepayments were roughly unchanged for lower coupons. The refinancing risk is greater for GNMA mortgages relative to conventionals (FNMA & FHLMC) due to the streamlined refinancing programs offered by the FHA (Federal Housing Administration) and VA (Veterans Affairs).
   Unlike the COVID period, borrowers are not yet seeing daily headlines of record low mortgage rates prompting them to refinance. As such, most borrowers are likely to take a wait-and-see approach with the anticipation of lower rates down the road even though mortgage originators have excess volume capacity. Therefore, we believe markets will need another sharp turn lower in long-term rates to drive a meaningful increase in prepayment activity. Absent such a move, and in an environment where 10-year US Treasury rates stabilize in a 4.0% – 4.5% range, we believe prepayments are far less likely to increase materially, as the vast majority of the outstanding mortgage universe remains far out of the money to refinance. 
5. Can interest-rate volatility come down further?
   A lower inflation environment is a better backdrop for rate volatility than a higher one, although the volatility of inflation itself is also an important driver of interest-rate volatility. The market’s increased confidence that the Fed’s hiking trajectory is over and rate cuts are within sight has helped move interest-rate volatility lower. While we anticipate rate volatility to stay structurally higher than the post-GFC era, more certainty on the Fed’s rate path would continue to lend support to lower volatility and tighter MBS spreads. 
6. Will election uncertainty hurt risk assets or the bond market?
   We do think there is potential for the election to impact Treasury yields and term premium based on policy expectations. Critical aspects of US macroeconomic policy such as trade policy, expiring tax cuts, fiscal policy, and government spending levels are likely to remain top of mind for investors. We think it is too early to predict how these policies will evolve, as we would need clarity not only in terms of who ends up in the White House, but also whether or not we have a divided Congress. 
7. How would reaccelerating inflation impact markets?
   While this is not our base case, it could result in wider spreads for many spread sectors, unwinding some of the positive year-end 2023 performance. Higher inflation can lead the Fed to push rate cuts further out, resulting in tighter lending standards and financial conditions, and a sustained inverted yield curve.
8. Is there room for mortgage spreads to tighten following the strong run over the past three months?
   While spreads have tightened by nearly 40 bps from the levels reached late last year, they remain attractive versus history. As can be seen in the chart below, mortgage current coupon-nominal-spread rankings are at their 68th percentile and remain attractive both on an absolute basis and also relative to investment-grade corporate credit. Even accounting for our view that MBS spreads will remain structurally higher than the tight spread environment during the post-GFC quantitative easing era, we believe mortgages look attractive at these levels and have room for spread tightening with a better inflationary environment and an improving technical backdrop.

Figure 1