Central bank observers want Federal Reserve Chairman Jerome Powell to remain on guard as the United States ramps up its vaccination efforts, putting an end to the COVID-19 pandemic in sight.

Specifically, some analysts believe Fed officials should start considering an adjustment to its about $ 120 billion per month program to purchase assets in a way that could help pave the way for a more fluid market operation in key segments of the US debt markets.

That wouldn’t mean cutting back on its monthly asset purchases. Rather, the policy change would be designed to be more responsive to a rising rate environment, particularly if demand for new US home loans cools, after the pandemic helped inaugurate the soaring house prices and record 30-year mortgage rates.

“As the Fed adjusts to an economy about to reopen (supported by a very strong fiscal tailwind), we expect their balance sheet policies to become increasingly flexible,” wrote a team of BofA Global strategists led by Satish Mansukhani, in a research note.

“One option for the Fed is to ‘switch’ certain purchases from MBS to UST,” the team wrote, referring to the central bank’s ongoing monthly asset purchases as part of the government guarantee. $ 7.3 trillion agency mortgage-backed securities market and about $ 20 trillion US Treasury market.

UST market thinks Fed footprint may not be large enough due to increasing UST supply and fearful investors amid rising rate trend , while the MBS market is showing more and more signs that the Fed may be too big. “

The 10-year Treasury benchmark yield TMUBMUSD10Y,
was up around 80 basis points on the year to date Wednesday at 1.67%, its highest level since January 2020. The sudden rate hike put pressure on top-tier stocks and raised fears of a possible surge in inflation as billions of dollars in stimulus swept through financial markets.

The $ 13.8 billion Vanguard Mortgage Backed Securities ETFs
+ 0.06%
was down 1.3% on the year to date Wednesday, according to FactSet. It tracks the Bloomberg Barclays US MBS Float Adjusted Index benchmark. The Janus Henderson Mortgage Backed Securities ETF
+ 0.08%
was 0.7% lower on the same section.

As investors turned away from growth stocks, pulling the Nasdaq Composite COMP,
+ 0.40%
In corrective territory, defined as a 10% decline from a recent high, other large-cap benchmarks continue to push into record territory. The Dow Jones Industrial Average DJIA,
was slightly higher on Wednesday, while the S&P 500 SPX,
was lower.

The surge in government bond yields has also raised concerns that the Fed may have a political misstep, namely that it could end up reversing its easy money policies sooner than expected, scaring investors off. investors and draining liquidity from the financial system.

The Federal Open Market Committee concludes a two-day meeting on Wednesday, and while no major policy changes are expected, investors will be listening for more clues as to the central bank’s thinking on its expectations for inflation and rising bond yields.

Read: Fed to stay easygoing this week as Powell channels his inner calm from Gary Cooper

At last check, the Fed had nearly $ 4.9 trillion in US Treasury debt and $ 2.1 trillion in agency mortgage debt, part of its record. 7.600 billion dollars in balance sheet.

The bulk of all new US home loans created since the 2008 financial crisis have been taken at higher credit standards than in the past. This allows the loans to be bundled and sold in the form of bonds with government guarantees, while generally offering holders a small withdrawal to Treasuries.

But after the recent round of asset purchases by the Fed, problems have arisen. Namely, the spread, or premium, that investors earn on certain government guaranteed mortgage bonds over benchmark T-bills has fallen to negative levels. A negative spread on mortgage bonds can make owning treasury bills a more attractive alternative, crowding out fund managers and hurting liquidity.

Adjusted spreads on MBS options turn negative

BofA Global

To counteract these pressures and help restore the market to function, Mansukhani’s team said the Fed may consider gradually reducing its monthly mortgage bond purchases, while reducing its net growing holdings of mortgage assets to 20. billion dollars, against 40 billion currently.

Scott Buchta, head of fixed income strategy at Brean Capital, said he agreed with the logic behind the call for the Fed to reduce mortgage bond purchases in the coming months, especially if mortgage origination volumes start to slow in the United States amid rising interest rates.

The interest rate on 30-year fixed-rate mortgages recently climbed to nearly 3.05%, a high not seen since July 2020, after falling to a record low of around 2.65% in January, according to housing giant Freddie Mac FMCC,

“The Fed’s MBS purchases will soon become a much larger percentage of overall output, and we will soon be issuing a lot more Treasury bonds where increased Fed support may / will be needed,” Buchta told MarketWatch.

“If we were to advise the Fed, that would be a direction in which we would go.”