Main Street Policy... Seriously?

September 21, 2012

The notion that Main Street will benefit from the Fed purchasing an additional $40 billion per month of agency-backed MBS is preposterous to us.
-Jason Doiron, Head of Fixed Income, Sentinel Asset Management, Inc.

In case you did not catch the press conference last week, Ben Bernanke believes that his latest round of quantitative easing will benefit Main Street. Seriously? The notion that Main Street will benefit from the Fed purchasing an additional $40 billion per month of agency-backed MBS is preposterous to us.

Why? Because for the past four years, investors have accepted the fact that central bank headlines and liquidity have a greater impact on asset prices than underlying fundamentals. To use central banker parlance, the fundamental valuation transmission mechanism has experienced a transitory interruption. The market has accepted this interruption and successful investors have found a way to ascertain the relevant facts and base their investment decisions on these. For successful investors, relevant facts drive the investment decision-making process. The same cannot be said for central bankers.

At Sentinel, our natural curiosity as investors leads us to ignore the Fed's story and focus on the facts. Bernanke provided the economic rationale for how the transmission mechanism works but the facts do not validate the story. Looking at the last three rounds of quantitative easing (QE2, Twist 1, and Twist 2) we see that 30-year mortgage rates were actually higher 60 days after the announcement by an average of 24.3bps.

The magnitude of the move may not be material but the fact that mortgage rates moved in the unintended direction makes us believe there is an error with either the rationale or the transition mechanism. Given this lack of factual support to the Fed's story, we thought it would be interesting to explore some of the additional intended and unintended consequences of the latest round of quantitative easing.

As bond investors, we find the unintended consequences of the Fed's actions on the MBS market most troubling. The Fed is already the dominant player in the agency-backed MBS market with $844 billion in holdings. They currently consume $25 - $30 billion of MBS per month through reinvesting the principal payments from current holdings. Starting immediately, the Fed will consume an additional $40 billion of MBS per month (open-ended) bringing the total amount to $65 - $70 billion per month.

To put this amount in context, the agency-backed MBS market issues roughly $135 billion of debt per month. Of this amount, our desk estimates that $35 - $40 billion is retained by MBS servicers / originators and therefore not available to investors. That leaves roughly $95 billion per month for investors. The Fed intends to purchase $70 billion per month or almost 75% of that available supply.

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