Tapering of the Federal Reserve’s balance sheet won’t sink the mortgage-backed securities market, said Boston Fed President Eric Rosengren, though prices may have to adjust to tempt investors into buying bonds currently being sucked up by the central bank.
“Our capital markets are deep enough that I’m not as worried about the ability to be able to fund those mortgages,” he told an audience Tuesday at a commercial real estate conference in New York. “Price will change, and I think market participants will step up as the price changes.”
The Fed holds $1.77 trillion of MBS among the assets on its $4.5 trillion balance sheet, which officials would like to begin shrinking at some stage this year, probably by gradually reducing the amount of proceeds they reinvest into new bonds from maturing ones. That could represent a significant loss of demand, depending on how the central bank decides to go about the task: the Fed bought $387 billion of mortgage bonds over the 12 months ended February just to maintain its holdings.
Rosengren said no decision had been made over when to begin or how to proceed with shrinking the balance sheet, which the Fed deliberately grew as an emergency measure during and after the financial crisis. He repeated his view that officials should start scaling back reinvestment relatively soon and go slowly.
“It should be highly tapered. And if it’s highly tapered, at least initially, there’d be some run-room for industry and private sector to get used to the fact that the Federal Reserve would be less active in this market,” he said. “With enough of a transition time, I don’t think it’s going to be all that disruptive.”
Investors may get more clues on what officials are thinking when the Fed releases minutes of last week’s policy meeting on May 24. They kept rates on hold and reiterated in their post-meeting statement that balance-sheet reinvestment would continue “until normalization of the level of the federal funds rate is well under way.”
Rosengren’s remarks chime with recent comments from other officials, including Kansas City Fed chief Esther George, who said earlier on Tuesday that she thought the process should start sometime this year and the central bank should begin by reducing MBS reinvestment.
Market participants remain anxious, recalling the 2013 episode when then-Fed Chairman Ben Bernanke sent bond yields soaring, in a so-called taper tantrum when he unexpectedly announced the Fed might begin slowing its asset purchases.
“They don’t really expect a similar market reaction this time around,” said Subadra Rajappa, the head of U.S. interest-rate strategy at Societe Generale, one of the Fed’s 23 primary dealers. “But I’m just not sure about that. Yes, Fed officials are doing a lot of ground work now in managing expectations, but ultimately we’ll have to see how this plays out.”
