What is quantitative easing (QE)?
Quantitative easing is a monetary tool used by a central bank to help directly influence the supply of money and indirectly influence demand and interest rates. The Federal Reserve utilizes QE by purchasing assets, such as Treasuries and mortgage-backed securities (MBS), with cash from its member banks. Through this purchasing mechanism, the Fed increases market liquidity as well as weakens the dollar against foreign currencies with the hope of stimulating the economy. This injection of U.S. dollars makes it easier for banks to lend out capital as well as creates a more enticing investment environment for international investors.
Along with increasing the money supply, the Fed uses QE to keep interest rates low. Through this tool, the Federal Reserve has bought enormous amounts of Treasuries from the federal government. This in turn inflates demand and keeps Treasury yields artificially low. Treasury yields are the benchmark for long-term interest rates that many of us see via auto and consumer debt rates. The Fed buys MBS in the same fashion, only with these securities mortgage rates are being affected. By keeping mortgage rates artificially low, the Fed supports the housing market. Quantitative easing has been used as a secondary option when the fed funds rate cannot be lowered anymore.
Where have we seen this before?
We have all seen quantitative easing relatively recently, and at the time this monetary tool was considered unconventional and thus was uncharted territory for the U.S. Back in 2008, then-Federal Reserve Chair Ben Bernake announced a plan for a series of central bank purchases which were broken off into three phases (QE-1, QE-2, and QE-3). These all took place between 2008 and 2014.
QE was initiated as a direct response to the 2008 Great Recession. During a Federal Open Market Committee (FOMC) meeting, the Fed announced QE-1 (December ’08 – June ‘10) that entailed purchasing $600 billion in Treasury notes, MBS, and bank debt. QE-2 (November ’10 – June ‘11) saw the central bank add another $600 billion in Treasury securities by the end of Q2 2011. From September 2011 through December 2012, the Fed also launched a strategy called Operation Twist where it bought long-term Treasury notes while upping their MBS purchases as short-term bills on their balance sheet matured. By doing so, Operation Twist helped keep long-term interest rates low and provided additional liquidity to the housing market.
In QE-3 (September ‘12 – October ‘14), the Fed announced it would buy another $40 billion in MBS as well as continue with Operation Twist. In December 2012, it was announced that QE-3 would be extended until reasonable employment and inflationary thresholds were maintained. This lasted until the FOMC announced in December 2013 it would begin tapering asset purchases. The announcement led to the 2013 Taper Tantrum—an event induced by market panic that triggered an unprecedented spike in Treasury yields. The Fed started reducing the actual holdings on its balance sheet in October 2017.
So, what now?
The current iteration of quantitative easing was initially announced in March 2020 to combat the economic woes brought on by the COVID-19 pandemic. The Federal Reserve stated at the time it would purchase $500 billion in Treasuries and $200 billion in MBS over the coming months—the Fed currently buys $80 billion in Treasuries and $40 billion MBS each month.
The central bank announced this week they are committed to starting the tapering process by the end of the year. The initial plan is to taper at a rate of $15 billion ($10 billion in Treasuries and $5 billion in MBS) in both November and December. This gradual reduction in new asset purchases is intended to cool off some inflationary pressures as well as signal as a precursor to interest rate hikes next year (although not explicitly stated by the Fed).
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Lipper U.S. Mortgage Funds Flows
The Lipper U.S. Mortgage Funds classification is generally comprised of funds that hold more than 80% fixed income and invest primarily in U.S. government agency and/or non-agency mortgage-backed securities. MBS are pools of home mortgages sold as a single security which often carry a higher yield than Treasuries.
In what appears to be a future environment of gradually rising mortgage rates, prepayment and reinvestment risk may work in these fund investors’ favor, at least in the short run. Borrowers tend to refinance and pay down their mortgages ahead of schedule when rates are falling causing lower interest income over the life of the security for the investor. Even the possibility of future cash flows not coming to fruition is a major risk for investors. Rising rates also afford these funds the ability to reinvest any prepaid capital at those higher interest rates.
While mortgage funds typically have higher yields than your average fixed income fund, interest rate risk and extension risk provide significant hurdles to climb. Interest rate risk is amplified when future rates are expected to rise; MBS prices are often more sensitive to interest rate movements than basic fixed income securities. Extension risk is the possibility that investors will be holding onto those MBS longer than originally expected due to borrowers putting off payments.
Lipper U.S. Mortgage Funds set a weekly record of inflows this week, attracting $1.7 billion in net new money. This prompted us to look at the historical flows for the Lipper classification during these periods of central bank purchases and tapering announcements. The classification’s record annual intake (+$28.5 billion) was in 2012 during Operation Twist, which as stated above significantly boosted the housing market while mortgage rates were kept artificially low. Lipper U.S. Mortgage Funds suffered their largest calendar year outflow the following year, during 2013 (-$10.6 billion). The classification bled money from the moment tapering was first discussed in June till the beginning of the actual reduction of asset purchasing that December. However, right after tapering began, the classification started seeing quarterly inflows again.
Fast forward to 2020, the COVID-19 pandemic left the market in shambles and full of uncertainty. The Federal Reserve stepped in and announced yet another quantitative easing program. After a few quiet quarters for Lipper U.S. Mortgage Funds, the classification saw strong inflows to end 2020 as the housing market gained momentum. Home prices and home sales boomed with low mortgage rates, increased savings, and an appetite to get away from the crowded cities. So far in Q4, the classification has realized $2.9 billion in inflows.
From looking at historical flows for Lipper U.S. Mortgage Funds it would appear there was an initial overaction in 2013 as to how quickly tapering would lead to an economic contraction in the real estate market. To give the benefit of the doubt, it was the first-time quantitative easing was used at this scale in the U.S. Once the tapering began in Q4 2013, investors realized economic activity persevered, as did inflows into the classification.
The triggering event seems to be the increase in the fed funds rate. If we zoom in on 2016 and look at the weekly flows for the Lipper classification, we can see the exact week flows started going sour. Investors were anticipating an imminent increase in rates, then on December 14, 2016, the fed funds rate increased for only the second time since 2008. From December 2016 to December 2018 there were eight subsequent jumps in rates.
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If recent history is any indication of future flows into Lipper U.S. Mortgage Funds, then we will likely continue to see persistent inflows into the classification until actual rate hikes are near implementation which many market participants believe to be in store for us in mid to late 2022.
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