In mid-June, the U.S. central bank raised rates and made clear its intentions to wind down a portfolio of bonds from a balance sheet that, as of June, totaled over $4.5 trillion — or more than 23% of U.S. GDP. How the Federal Reserve manages this behemoth bond portfolio has implications for general economic growth as well as for mortgage rates and housing.

Mortgage-backed securities consist of pools of loans guaranteed by U.S. housing agencies Fannie Mae and Freddie Mac as well as Ginnie Mae — the Government National Mortgage Association, a corporation within the Department of Housing and Urban Development.

MBS, together with debt issued by the agencies, currently account for approximately $1.8 trillion of the Fed’s portfolio. As they explained on June 14, the central bank’s policymakers said that they expect to begin the wind-down process this year, provided that the economy continues its path of steady, broad-based growth. Initially, they expect to hold off from reinvesting $4 billion in agency debt and MBS each month. This cap on the monthly reduction would then increase in steps of $4 billion at three-month intervals over a 12-month period until it reaches $20 billion a month.

The Fed’s investment in MBS was a shift from its typical management of borrowing costs at the short end of the yield curve; rather, the Fed used its MBS portfolio to manage long-term rates. This aspect of quantitative easing via the mortgage market served several purposes. It offered homeowners the opportunity to lower monthly mortgage payments through refinancings. And with interest rates so low, investors deployed cash to finance the purchase of homes and convert them to rentals. Both results helped establish a bottom to home prices and the desired effect was the elimination of a negative wealth effect and the increase of net income available to encourage consumption by households.

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It is important to note that the Fed was a policy buyer, not an economic buyer. In other words, it bought not for investment returns but to affect the shape of the yield curve and to lower long-term interest rates. The net effect of the Fed’s purchases has been to reduce MBS holdings of other investors — in particular, the government-sponsored enterprises, foreign investors and households, among others.

The Fed’s intent to retreat from the MBS market has been well telegraphed, except for the start date and some minor technical matters. The question now is, at what price will there be sufficient buyers to step in and sop up the supply of MBS that comes in each month as homeowners refinance mortgages and consumers borrow money to buy homes? It is unknown how the Fed’s purchase and portfolio activity impacted the investment preferences of economic buyers. The change in the Fed’s buying habits likely will widen the yield premium over Treasuries demanded by MBS investors and push mortgage rates higher by 25 to 40 basis points as the portfolio is worked off in an orderly transition. However, this will take quite some time because, if the Fed is successful in pushing rates up, the increase in borrowing costs will reduce homeowner refinancing activity and the pace at which mortgages pay off.

No matter how the Fed choreographs its retreat, there may be subtle nuances in how the MBS market responds to the pullback. For example, Ginnie Mae-guaranteed securities are viewed as cash assets by bank regulators and they are favored by financial institutions, so the spreads for these securities may not widen as much as yield premiums for Fannie Mae- and Freddie Mac-guaranteed MBS. As a result, there may be less of an impact for a borrower opting for Ginnie Mae-guaranteed mortgages when buying a home or refinancing a mortgage.

If mortgage rates rise slowly as the economy continues to grow, the impact from the Fed’s unwind on housing likely will result in a decline in refinancing activity, specifically cashout refinancings that allow homeowners to borrow against equity in their homes. In a higher rate environment, homeowners may turn to home equity loans because they want to retain the low rate of their current mortgages.

A gradual, modest rise in mortgage rates in a growing economy won’t have much impact on homebuilding as the housing market suffers from a lack of supply. The same is true when it comes to sales of new and existing homes. Critically important is whether incomes rise at roughly the pace of housing costs, which include home prices and mortgage rates.

Some of the rise in interest rates ahead of the 2016 U.S. presidential election was due to a shift among global central banks away from the use of negative interest rates. Right around the presidential election, the U.S. saw a jump in rates. The increase was driven by at least three factors: expectations of increased economic growth resulting from fiscal policy change, the potential for growth in inflation and expectations that monetary policy would shift away from use of the central bank’s portfolio. So far, we’ve seen no fiscal policy changes implemented, but the shift in the Fed’s portfolio is getting closer.

Letting the portfolio run off is rightly interpreted by the market as a tightening of monetary policy. After all, the Fed was clear that expanding the portfolio was an element of their strategy on easing monetary policy, and the mortgage component clearly targeted housing. The Fed suggests that once the portfolio runoff is under way, this wind-down will continue passively in the background; however, the Fed also stated that it would be prepared to resume its reinvestment policy or alter the size and composition of its balance sheet if economic conditions warrant.

At the same time, there are some other important factors to consider when it comes to the central bank’s change in policy on its MBS portfolio. In this case, the topography of credit markets has changed since the Fed adopted its policy of buying MBS. When the Fed was building its MBS portfolio the GSEs were shrinking theirs. Today, the GSEs have been directed to reduce their portfolios to a set level and will not be absorbing that volume back as the Fed exits. The central bank will also have to consider whether economic buyers will smoothly absorb the MBS runoff and at what cost.