Understanding the Fed Announcement

Since the Fed released its statement yesterday afternoon, MBS markets have staged a very strong rally for several reasons. First, quite simply, the Fed confirmed that there are “significant downside risks” to the US economic outlook. Slower economic growth reduces inflationary pressures, which is favorable for MBS markets. Second, the Fed announced the widely expected Operation Twist program. This program will extend the average maturity of the Fed’s portfolio by purchasing $400 billion of longer-term Treasury securities and selling an equal amount of shorter-term Treasuries. The increased demand for longer-term assets is intended to help push longer-term rates lower. The third major element from the statement helping MBS markets was a surprise to most investors. The Fed will begin to reinvest MBS principal payments (from prepayments and maturing securities) in additional agency MBS. Until now, the Fed has been reinvesting the MBS principal payments in Treasury securities. With roughly $885 billion in MBS holdings in the Fed’s portfolio, these principal payments are expected to create a significant source of additional demand for MBS, and this measure is specifically targeted at keeping mortgage rates at low levels. As usual, the impact of the economic news was priced in very quickly, similar to the reaction to prior Fed announcements about purchasing MBS.