Mortgage-backed momentum

The Federal Reserve's decision to ease monetary policy has led to lower short-term interest rates, while long-term Treasury yields have remained stable, benefiting mortgage investors. Mortgage-backed securities (MBS) have consistently offered higher yields than Treasuries, with spreads often reaching the high end of historical levels, presenting a valuable opportunity for investors throughout 2023 and 2024. This is a stark contrast to 2022, when the sector faced challenges due to low demand and widening spreads.

The transition from quantitative easing to quantitative tightening by the Fed significantly reduced demand for MBS from major holders like the Fed and domestic banks, leading to wider spreads and underperformance in the sector. However, looking forward to 2025, there are promising opportunities in MBS for strong total returns.

Despite a strong economy and persistent inflation, the Fed is expected to continue easing monetary policy in 2025, albeit at a slower pace. The risk of prepayment remains low as most mortgages were financed at rates below 5%, reducing the likelihood of refinancing unless rates drop significantly. Additionally, a steepening yield curve could benefit buyers such as domestic banks looking to enhance their net-interest margins.

Furthermore, potential regulatory changes under the Trump administration could lead to reduced banking regulations and capital requirements, attracting new buyers, including relative-value investors. These factors collectively suggest a favorable outlook for MBS investments, emphasizing the importance of strategic positioning to capitalize on these opportunities.