The Federal Reserve may be poised to resume interest-rate cuts this week, but it could do more to ease US mortgage costs and stimulate housing by using different tools involving its balance sheet, says Pacific Investment Management Co.
Even as traders fully expect the Fed to cut their short-term target by a quarter-point toward 4% this week, US mortgage rates — which are determined by the market — remain elevated above 6%, limiting the effectiveness of rate policy to stimulate housing. That's partly a function of other central bank efforts aimed at shrinking the Fed's vast store of bonds amassed during Covid-era quantitative easing.
The Fed has allowed principal and interest payments on mortgage debt holdings to "roll off" its balance sheet rather than reinvest them, and that has resulted in the mortgage market trading wider than normal over benchmark Treasury yields. If the Fed were simply to reinvest the roughly $18 billion in current monthly "roll-off" into new mortgage securities, that alone could compress mortgage spreads by as much as 0.3 percentage point, Pimco said.
"Wide mortgage spreads present a problem for monetary policy transmission," Marc Seidner, CIO of non-traditional strategies, and Pramol Dhawan, portfolio manager at the $2.1 trillion asset manager said in a note published on Tuesday. "In a cycle where interest-rate policy is politically fraught and inflation remains sticky, the Fed may find that the most effective easing tool is already hiding in plain sight."
In fact, reinvesting mortgages "could deliver as much bang for the buck as a 100 basis-point cut to the federal funds rate," which is what has historically been needed to achieve a similar drop in mortgage rates, they wrote.
An even more aggressive approach they dub "Operation Mortgage Twist" would see the Fed sell $20 billion to $30 billion of legacy mortgage bonds each month and reinvest proceeds into current securities. This would also have the effect of reducing a gauge of interest-rate risk on the Fed's balance sheet, according to the Newport Beach, California firm.
Pimco estimates this "twist," invoking a term for balance-sheet maneuvers the Fed has employed at times in the past, could push mortgage rates down by as much as half a percentage point.
In contrast, should the central bank continue with its current approach, mortgage rates would likely "remain elevated through 2026, making homeownership a luxury good reserved for the wealthy," Pimco said. "The question isn't whether Fed officials can improve this situation – it's whether they will," the firm added.
To be clear, the Fed historically has used its balance sheet in times of crisis, to provide emergency liquidity to financial markets or to provide broad-based stimulus. Outside crises, they have never intervened to provide targeted help to the housing market, or any other individual sector.
The importance of longer-dated rates for the U.S. economy and the cost of home ownership has been regularly highlighted by Treasury Secretary Scott Bessent. In recent months, the White House has pushed for a faster pace of easing that would arguably help reduce longer-dated yields.
Newly appointed Fed Governor Stephen Miran, at his confirmation hearing in Congress this month, mentioned a statutory objective of the central bank to pursue "moderate long-term interest rates." His citing of this so-called third mandate raised debate among some traders about the potential for the Fed to at some point employ more unorthodox efforts to influence borrowing costs.
