After its meeting concluded on June 14th, the Fed provided some details about the plan to reduce its holdings of U.S. Treasuries and agency debt and mortgage-backed securities (MBS).
Regarding the starting time for the reductions, Fed Chair Yellen said that they could begin “relatively soon if the economy performs in line with the Fed’s forecasts. This comment caused investors to anticipate that the starting time will be in September or October, which was sooner than expected.
In a document called the Policy Normalization Principle and Plans, the Fed laid out additional information.
They will reduce their holdings by not reinvesting all the principle payments received. Over the last few years, they have held the level of their holdings steady by reinvesting all the principle payments received. The amount of principle payment received that will not be reinvested will start at $10 billion per month and will grow by $10 billion every three months until the monthly total reaches $50 billion. The reduction then will be capped at $50 billion and will continue until the size of the Fed’s holdings has fallen to the desired level. The Fed did not disclose the desired level but did say they expect the monthly reductions to continue for several years. These details told investors that future demand from the Fed for MBS may be lower sooner than had been expected, and that was slightly negative for mortgage rates.
Roughly 40% of the reduction described above will occur in the Fed’s holdings of MBS. This means that at the implementation of the plan there will be around $4 billion less demand per month from the Fed to buy new MBS. The reduced demand will grow to around $20 billion a month after twelve months. This may not sound like a large amount, but it represents approximately 25% of the total agency MBS issued in recent months. If other factors remain the same, the basic principles of supply and demand would suggest that a reduction in demand of this amount should have a negative effect on MBS prices and therefore mortgage rates.