In 2006, foreign investors created demand for MBS and filled in the gap that other investors like the GSEs used to fill. Street analysts are predicting that this demand is going to continue this year. Specifically, UBS analysts said in a report released last week that both official and private foreign investors will remain very active in the U.S. MBS sector.
On the government side of foreign investing, analysts explained that central banks have fundamentally changed their foreign exchange reserve equal to three to six months of imports, and were invested mainly in U.S. Treasury Bills, analysts said. This, in turn, resulted in dollars being available to cover the imports. They also said that asset liquidation did not really result in losses. But, in the past decade, foreign exchange reserves are up more than three fold (from $1.55 trillion at year end 1996 to $4.75 trillion at the end of third quarter 2006). Because of this, central banks reoriented their foreign exchange reserve management to reflect a total return tendency. The U.S. dollar share of foreign exchange reserves has been notably constant at roughly 63% of the total. However, they said that central banks have significantly increased their allocation of dollar reserves toward spread product. And, in the past few years, the mortgage market has, according to analysts, benefited disproportionately from this move.
UBS also mentioned that it holds a seminar for central bankers once a year in June. Before this seminar, analysts said that a survey is distributed asking central banks what asset classes they have approved, how their reserve management changed in the past year, and how they expect it to change the next year. Analysts enumerated highlights from the 2006 survey. The first is that in 2006, 44% of the central banks were approved to invest in MBS/ABS. This is up from 2% in 1998. Also, another highlight is that only 3% of respondents invested only in U.S. Treasurys, which dipped from 31% four years ago. The third point is that 64% of respondents stated they bought securities with embedded options, which increased from 44% in 2005 and 18% in 2001. The last point brought up was that MBS was the asset class most frequently mentioned for increased allocations in 2006 and 2007.
Placing some reasonably conservative estimates on central bank purchases, analysts projected that central banks could really absorb half of the net new 2007 supply. This also does not consider the demand for MBS assets from "stabilization funds". The foreign exchange reserves of the oil exporting countries have not risen much this past year, despite massive surpluses. The reason for this is that the funds are not going into foreign exchange reserves, but rather, into stabilization funds such as pension and investment funds. Two of the best-known examples, according to UBS, are the Strategic Petroleum Fund in Norway and the Abu Dhabi Investment Authority. Analysts projected about $1.5 trillion in stabilization fund assets, growing at the rate of $400 billion per annum. This also does not consider demand from private investors, who have also been quite active. Japanese banks have been large MBS investors. These have considerable cash at hand, combined with a limited appetite to take interest rate exposure in the Japanese market, as the Bank of Japan is in the beginning stages of normalizing interest rates, analysts said. That is, analysts believe that the Bank of Japan is probably going to be on a tightening mode over the next year, which means generating capital losses on their Japanese bond positions. There are few prospects for loan growth considering that Japanese corporations are currently cash rich. These firms also don't want to put debt on their balance sheet. In contrast to this, in the U.S., the Federal Reserve is likely to be easing, this will be creating capital gains on U.S. bond positions.
Specifically, in the U.S. mortgage market, the banks could get capital gains, as well as positive carry while they are waiting. It should be noted that foreign investors are yield sensitive, analysts said, and are expected to decide to add more when rates are relatively attractive.
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