The increases in mortgage rates over 2022 has reduced incentives for borrowers to refinance, resulting in lower prepayment rates and decreased principal pay downs on Federal Reserve Agency mortgage-backed securities (MBS) holdings. The Fed has raised the amount of MBS it will allow to run off its balance sheet each month to $35 billion. This reduction of demand from the Fed no longer reinvesting early payoff money should push rates up. However, because prepayment speeds from refinancing and mortgages paying off are slowing, the Fed is unlikely to even get to $35 billion in monthly maturing MBS. So, the run off will be slower than permitted. Prepayments of mortgages should continue to be driven primarily by the personal motivations of mortgage holders (e.g., whether to move to a new home) rather than by the ability to refinance at a lower interest rate.

For Agency MBS the focus is on “principal payments” because unlike Treasuries, which have fixed maturity dates, mortgages pay principal each month and these principal payments are not known in advance. And unlike Treasury securities, which are reinvested on the same day that they mature, settlements (the ultimate exchange of securities and payments) of Agency MBS occur on different dates than the principal payments are received. This can result in variability of MBS holdings over the course of a month. Reinvestment purchases for a given month are completed in the middle of the following month and Agency MBS purchases do not settle until up to a month and a half in the future.

The Federal Reserve does have prior experience reducing the size of its balance sheet. The Fed shrank its balance sheet by $700 million between 2017 and 2019. Sure, there are several differences between the current environment and the last time the Fed did this. The size of the Federal Reserve’s balance sheet is considerably larger this time around, and the pace of runoff will be faster. The composition of liabilities is also different, but the important thing to know is that this will put upward pressure on mortgage rates moving forward.

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