Navigating Fed Uncertainty: Why MBS Offer Safe Haven in Turbulent Times

The Federal Reserve faces unprecedented political scrutiny as President Donald Trump's public attacks on Chair Jerome Powell escalate, framing a critical inflection point for monetary policy. This heightened uncertainty—driven by tariff-induced inflation volatility and demands for rate cuts—has created a unique opportunity in the mortgage-backed securities (MBS) market. Agency MBS, particularly those with long durations, now present a compelling investment thesis, offering both defensive attributes and convexity-driven upside as the Fed's policy path unfolds.

The Fed's Crossroads: Political Pressure vs. Economic Data

The Federal Reserve's independence is under siege. Trump's relentless criticism of Powell—labeling him “a moron” and demanding aggressive rate cuts—has intensified as the administration seeks to reduce interest payments on the national debt. However, the Fed's hands are tied by the very policies Trump enacted: tariffs introduced in early 2025 have injected significant uncertainty into inflation forecasts. Powell has repeatedly emphasized that rate cuts depend on data, with the FOMC projecting two cuts by year-end, though timing remains contingent on labor market resilience and inflation trends.

This disconnect between political demands and economic fundamentals has fueled market volatility. The Fed's hesitation to cut rates earlier—despite traders pricing a 76% chance of holding rates steady in July—reflects its cautious approach to tariff-driven inflation risks. Yet, the escalating rhetoric raises the likelihood of a preemptive rate cut, even if only to quell political pressure.

MBS Spreads: A Mispriced Opportunity in a Widening Gap

Agency MBS spreads over Treasuries have surged to 68 basis points (bps)—far exceeding their 15-year average of 58 bps. This widening reflects two key dynamics:
1. Market Pessimism on Growth: Investors are pricing in 1–3 rate cuts by year-end, driven by concerns over wage growth, supply-chain disruptions, and geopolitical risks.
2. Supply Dynamics: A 21.4% year-over-year increase in MBS issuance in 2024 has created short-term oversupply pressures, further widening spreads.

Meanwhile, investment-grade corporates face their own challenges. Their spreads have risen to 94 bps amid record supply and fears of credit downgrades due to tariff-driven earnings pressures. This divergence creates a relative value opportunity for MBS: their government-backed guarantees eliminate credit risk, and their low prepayment risk (due to mortgage rates above 6%) reduces negative convexity—a stark contrast to corporates' vulnerability to credit downgrades.

Why Overweight Long-Duration Agency MBS Now?

The current environment is tailor-made for MBS investors:
- Convexity Benefits: With prepayment risk at historic lows, agency MBS exhibit positive convexity—their prices will rise disproportionately as rates decline. This is a stark reversal from the negative convexity fears of earlier years.
- Fed Rate Cuts: Even a single 25-basis-point cut by year-end could catalyze a sharp narrowing of spreads. The Fed's eventual pivot to easing will amplify MBS price appreciation, especially in longer-duration securities.
- Defensive Profile: Agency MBS have historically outperformed equities and IG corporates during market selloffs. Their short duration (now averaging 3.5 years) further mitigates rate risk, making them a resilient portfolio hedge.

Risks and Considerations

• Inflation Persistence: If core PCE inflation stays above 3% through 2026, the Fed may delay cuts, pressuring MBS prices. However, the Fed's credibility on its 2% target and the fading impact of tariffs suggest this risk is overpriced.
• Geopolitical Shocks: Trade disputes or military conflicts could reignite inflation fears, but agency MBS's government backing insulates them from credit risk, even in recessions.

Conclusion: Position for Fed Easing with Agency MBS

The interplay of political Fed uncertainty and data-driven policy hesitancy has created a rare mispricing in MBS spreads. With convexity risks minimized and the Fed poised to cut rates by year-end, agency MBS—particularly those with long durations—offer a compelling risk-reward trade. Investors should overweight this sector now, capitalizing on the widening spread opportunity while positioning for a Fed pivot that could unleash significant price appreciation.

In a world of escalating uncertainty, agency MBS stand out as a rare blend of safety and upside—a testament to their enduring role as a cornerstone of prudent portfolio construction.