Almost any likely path for U.S. interest rates will leave the Federal Reserve owning as much as $600 billion in mortgage bonds a decade from now. Recent central bank research suggests that the Fed’s efforts to offload these securities by letting them mature without replacement are facing challenges, raising questions about whether active sales might be necessary in the future. The findings highlight the difficulties the Fed encounters as it seeks to return to a portfolio composed mostly of Treasury securities.
Key Facts:
- The Federal Reserve could still hold $600 billion in mortgage bonds by 2035, according to recent research.
- Mortgage-backed securities (MBS) held by the Fed are unlikely to be paid off early due to low mortgage rates, trapping the Fed in long-term ownership.
- The Fed has reduced its balance sheet from $9 trillion to $7.2 trillion since 2022 through quantitative tightening (QT).
- Fed officials have not ruled out the possibility of selling mortgage bonds outright in the future.
- As of July, it was expected that the Fed’s balance sheet reduction might end in April 2024.
The Rest of The Story:
The Federal Reserve, through its process of quantitative tightening (QT), has been reducing its overall balance sheet after peaking at $9 trillion. Despite this, recent research reveals that the central bank will likely still be holding hundreds of billions in mortgage-backed securities (MBS) over the next decade. These bonds, unlike government securities, have lower interest rates—most under 4%—meaning they are not likely to mature early or be refinanced due to the “lock-in effect.”
Homeowners with these low-rate mortgages are holding onto their properties, which keeps the underlying mortgage debt from being paid off early. “Even a notable decline in mortgage rates would likely not materially affect” this situation, the research says. As a result, the Fed’s efforts to shrink its balance sheet by allowing mortgage bonds to expire are expected to move very slowly.
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The Fed has been clear that it prefers a bond portfolio mostly made up of U.S. Treasury securities rather than mortgage bonds. However, the sluggish nature of the MBS market means that even with favorable interest rate conditions, the Fed may still hold up to $600 billion in these securities by 2035. This prolonged period of bond retention has led some experts to suggest that the Fed might eventually need to consider active sales of its mortgage-backed securities.
Commentary:
The Federal Reserve’s long-term holding of mortgage-backed securities should raise concerns about the government’s heavy involvement in this market. With interest rates at current levels, homeowners are not selling their homes or refinancing their low-rate mortgages, leaving these bonds on the Fed’s books for years to come. This contrasts sharply with the more predictable nature of U.S. Treasury bonds, which are far more secure and liquid.
Allowing the government to maintain such large MBS holdings could distort the mortgage market and further entrench the Fed in areas best left to the private sector. Instead of holding onto mortgage bonds, which may take decades to unwind, the Fed should shift its focus toward selling these securities and transitioning to a portfolio dominated by U.S. Treasury bonds, which are safer and less likely to disrupt economic policy.
The Bottom Line:
The Federal Reserve’s balance sheet, although shrinking, is still burdened by mortgage-backed securities that could linger for years. With interest rates unlikely to prompt an early exit for homeowners from their low-rate mortgages, the Fed may be forced to consider more aggressive strategies, such as active bond sales, to reach its goal of a portfolio made up primarily of U.S. Treasuries.
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This situation reveals the risks of the government maintaining a high level of influence in the mortgage market for such an extended period.
