Mortgage-backed momentum

The Federal Reserve’s pivot to easing monetary policy in September resulted in lower short-term interest rates. But while long-term Treasury yields, used to price 30-year mortgage rates, have not declined, mortgage investors have benefited. Throughout much of 2024 and 2023, mortgage-backed securities (MBS) offered investors value, with higher yields than Treasuries of similar tenors and spreads between the two often at the high end of historical levels. This contrasts with a challenging 2022, when the sector struggled with low demand and significant spread widening.

But just as critical was when the Fed shifted gears from years of quantitative easing, purchasing billions of Treasury and mortgage securities, to quantitative tightening, when it allowed some of these securities to roll off its balance sheet. Demand for MBS during this period by its two largest owners—the Fed and domestic banks—was drastically reduced, leading to larger spreads and sector underperformance. 

This brings us to 2025. While spreads have widened, we see further opportunity in MBS for strong total returns. Reasons for support include:

• The Fed still projecting cuts While policymakers have trimmed their expectations for the pace of cuts in the face of stubborn inflation and a strong economy, we still expect further easing in 2025.
• The low probability of prepayment risk The vast majority of mortgages were financed at an interest rate below 5%. Most homeowners likely will not have the incentive to refinance unless rates dropped below 5%, which we do not expect in the short term.
• The steepening yield curve A steepening curve would be beneficial for buyers, such as domestic banks as they seek to capture net-interest margin. 
• New buyers Some Wall Street research has indicated the Trump administration may reduce banking regulations. One could be the reduction of capital requirements. Additionally, there may be additional buyers in the form of relative-value investors.