Fed Paper Outlines Gradual Process to Unload Central Bank’s Mortgage Bonds, According to Reuters

By Michael S. Derby

Recent research from the Federal Reserve indicates that regardless of the trajectory of U.S. interest rates, the central bank may still hold around $600 billion in mortgage bonds a decade from now. This finding could strengthen the argument for selling these securities to align the portfolio more closely with Treasury holdings.

The study, released last week, highlights that whether interest rates are higher, lower, or remain stable—as central bankers anticipated back in June—the Fed will likely find it challenging to reduce its mortgage bond holdings simply by allowing them to mature without replacement. Unlike Treasury securities, the mortgage-backed securities (MBS) owned by the Fed have a minimal risk of early retirement due to the current low rates attached to them.

The authors of the study point out that almost all of the Fed’s MBS holdings carry interest rates below 4%, which is significantly less than current market yields. This situation is creating a “lock-in effect,” whereby homeowners with low-rate mortgages are unlikely to refinance or sell their properties.

The authors note that “even a notable decline in mortgage rates would likely not materially affect” this trend.

Since 2022, the Federal Reserve has been reducing the size of its balance sheet by allowing its Treasuries and mortgage bonds to mature without replacement, decreasing its total holdings from a peak of $9 trillion to approximately $7.2 trillion.

This process, now known as quantitative tightening (QT), aims to normalize monetary policy following the COVID-19 pandemic. The Fed intends to tighten liquidity to a level that gives it better control over short-term rates and facilitates normal fluctuations in money markets. However, the central bank is still evaluating how much further it needs to go.

Additionally, the Fed seeks to eventually shift its bond portfolio to primarily include Treasury securities. As of July, market observers anticipated that the QT would conclude in April while still allowing mortgage bonds to expire without being replaced.

Fed officials are working to differentiate QT from the current interest rate policy, which is leaning towards a series of cuts after the central bank’s recent decision to lower borrowing costs by half a percentage point.

Despite a reduction in mortgage bond holdings from a peak of $2.7 trillion to the current $2.3 trillion—primarily due to the maturation of Treasury bonds—the implications of the research suggest that the central bank’s mortgage holdings could decrease to $1.2 trillion by the end of 2030 and reach $700 billion by the end of 2035 if interest rates follow early summer expectations. Should rates drop further than expected, the holdings could still stabilize at approximately $600 billion by 2035.

The findings in the research underline the growing conversation around potential active sales of mortgage bonds, although Fed officials have not explicitly addressed this possibility. Analysts suggest that the central bank may need to consider the active sale of mortgage bonds more seriously, even on a small scale, to avoid being encumbered by these assets for an extended period.