The Federal Open Market Committee (FOMC) today voted to buy an added $40 billion in agency MBS each month.

The committee also said that the Federal Reserve will maintain its policy to reinvest principal payments from its holdings of agency debt and MBS. The commitment is open ended and the MBS purchases will start tomorrow, Sept. 14.

According to a JPMorgan Securities report released this afternon, along with the $25 billion to $30 billion per month now reinvested into agency MBS as part of Operation Twist, the added $40 billion of buying will bring total monthly purchases to more than $65 billion. This comprises 55% of the gross monthly supply of all agency MBS, analysts said.

Meanwhile, Bank of America Merrill Lynch analysts said that the FOMC's decision is stronger versus their initial expectations and has led them to shift to an overweight recommendation on the MBS basis from a neutral stance.

MBS valuations can stay rich and tighten further based on the strong technical backdrop the announcement creates, the lower volatility outlook, and the roll specialness potential. BofA Merill analysts, however, expect these tights to be tested.

The Fed's additional purchases will be aside from the reinvestment of paydowns that has been running between $25 billion to $30 billion per month and has brought total gross MBS purchases to about $65 billion to $70 billion per month, BofA Merrill said.

The FOMC statement has conditioned these purchases on labor markets improving. This could imply Fed purchases will continue into the foreseeable future considering the uncertainty that QE3 will drive employment and cause a more favorable technical backdrop versus QE1, analysts said. Because of this, tight MBS spreads can prevail for a longer time period than under QE1, they added.

JPMorgan explained that during QE1, the Fed’s 30-year purchases many times represented over 100% of 30-year gross issuance. Although the Fed would rather not cause a market disruption, analysts said previous behavior shows that its first priority is to drive MBS prices higher. There is also no guarantee that the Fed will change the composition of its purchases and buy proportionally more GNMAs and 15-year mortgage-backeds, they explained.

BofA Merrill analysts added that this volume of purchases would absorb a considerable share of MBS gross issuance. August MBS gross issuance reached $122 billlion divided into $88 billion in conventionals ($66 billion in 30s, $22 billion in 15s) and $34 billion in GNMAs, which were mostly in 30s. The Fed bought $23 billion of conventional 30s, $2.5 billion of conventional 15s and $3 billion of GNMAs. While most of the Fed's purchases will be in 30s, there could be higher absorption of Golds, GNMAs and 15s.

BofA Merrill analysts also said that primary mortgage rates can inch lower as an extended outlook for low rates and high origination margins can result in servicers building capacity.

Faster prepayment speeds should support specified payups particularly in the higher coupons. The Fed's part in the roll market should drive payups on specified 3.5s as rolls trading at or through fail will bring down payups, they said.

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