Unlocking Value in Mortgage-Backed Securities: Navigating the Fed's Pause and Inflation Crossroads

The Federal Reserve's June 2025 policy meeting underscored a critical divergence: while central bankers remain cautiously optimistic about long-term inflation control, markets are pricing in a more pessimistic near-term outlook. This disconnect has created a compelling opportunity in mortgage-backed securities (MBS), where valuation spreads now offer a premium relative to Treasuries. For investors seeking stability in a volatile environment, MBS present a rare chance to capitalize on mispricings driven by conflicting signals from the Fed and the market.

The Fed's Dual Narrative: Caution and Certainty

The Federal Open Market Committee (FOMC) projects core PCE inflation to moderate from 3.1% in 2025 to 2.1% by 2027, aligning with its 2% target. Fed Chair Powell emphasized that risks to inflation remain “balanced” at longer horizons but tilted upward in the near term due to persistent wage pressures and supply-side disruptions. Meanwhile, the central bank's federal funds rate path remains steady at 3.9% for 2025, with gradual declines to 3.4% by 2027. This cautious stance reflects the Fed's commitment to data-driven policy, even as geopolitical risks and trade tensions loom.

MBS Valuations: A Mispriced Opportunity

Despite the Fed's measured approach, MBS spreads over Treasuries have widened to 68 basis points (bps)—above the 15-year historical average of 58 bps. This gap is driven by two factors:
1. Market Pessimism on Growth: Investors have priced in 1–3 rate cuts by year-end, reflected in the 10-year Treasury yield's drop to 4.21% from 4.58% in early 2025.
2. Supply Dynamics: Issuance of MBS rose 21.4% year-over-year in 2024, increasing liquidity but also creating short-term oversupply pressures.

Why the Valuation Gap Matters

The Fed's projections suggest inflation will stabilize, but markets are pricing in a higher probability of disinflationary risks (e.g., slower wage growth, softer consumer demand). This creates a value asymmetry in MBS:
- Upside: If the Fed's inflation outlook proves accurate, MBS spreads could narrow as Treasuries underperform amid stable rates.
- Downside: Even in a recession scenario, agency MBS are backed by government guarantees, limiting credit risk.

Investment Strategy: Exploit the Gap

Investors should consider overweighting agency MBS in fixed-income portfolios for three reasons:
1. Relative Value: The 68 bps spread over Treasuries offers a yield cushion in a low-duration, low-volatility asset class.
2. Duration Management: MBS have shorter effective durations than Treasuries, reducing sensitivity to rate hikes.
3. Inflation Hedge: While not a direct hedge, MBS prepayment risks are muted in a low-growth environment, preserving principal.

Risks and Considerations

• Inflation Persistence: If core PCE inflation stays above 3% through 2026, the Fed could delay cuts, widening MBS spreads further.
• Geopolitical Shocks: Tariffs or supply chain disruptions could reignite near-term inflation, altering Fed policy expectations.

Conclusion: A Strategic Bet on Stability

The Fed's pause and the market's inflation skepticism have created a rare mispricing in MBS. By overweighting agency-backed securities, investors can capture a yield premium while hedging against both rate volatility and moderate inflation. As the Fed's long-term inflation target remains credible, this gap is unlikely to persist indefinitely—making now the optimal time to act.

Actionable Takeaway: Allocate 5–10% of fixed-income portfolios to agency MBS funds or ETFs (e.g., MBB, MBG) to exploit the valuation gap. Monitor core PCE inflation data and Fed communications for shifts in the inflation narrative.

In an era of uncertainty, MBS offer a rare blend of safety, yield, and strategic opportunity. The Fed's pause is your signal to move.