Finding the Right Level of Support for Capital Markets and Mortgage Rates
The U.S. Federal Reserve has taken extraordinary steps to facilitate liquidity in capital markets. While these actions have begun to stabilize and normalize valuations, in the lowest risk “core” of the fixed income markets – trading of Treasuries and agency mortgage-backed securities (MBS) – issues still remain with risk transfer and liquidity.
We believe it is particularly critical to maintain stability and liquidity in core fixed income markets, or risk instability in assets further out the risk spectrum. A continuation of the Fed’s operations would likely stabilize this core and allow liquidity to more fully normalize. We see that as a necessary, but not sufficient step in the process of proper functioning in all areas of fixed income markets, including riskier credit and securitized products. All of these markets have an important function in the real economy, by facilitating credit for smaller and midsized business, housing and commercial real estate. Indeed, stabilizing the core is the first step in creating the most efficient and effective transmission of the easier monetary policy out into the real economy.
Recent rapid deleveraging by real estate investment trusts (REITs), hedge funds, volatility-targeting investors, and others caused meaningful spikes in realized volatility in assets that are generally deemed to be “risk free” due to their explicit or implicit government guarantee: U.S. Treasuries, Treasury Inflation-Protected Securities (TIPS), and U.S. agency MBS*. The rush to sell caused sharp and significant dislocations in valuations, leading to a substantial rise in margin requirements, in turn driving a need to deleverage, which further exacerbated market volatility and illiquidity. The Fed stepped in to thwart this vicious cycle via large-scale purchases of Treasuries and MBS, and valuations have since begun to normalize.
While valuations appear more normal now than in the past few weeks, not much else is normal in terms of the functioning of these markets. Aside from Fed operations, liquidity remains quite challenged, and low liquidity usually leads to more volatility, higher trading costs, and greater risk aversion – factors that can all contribute to reduced bank lending to the real economy. Given these realities, the Fed’s participation seems necessary for quite some time to normalize dynamics in normally liquid markets.