Heading into 2010, the  mortgage market was looking at the Federal Reserve winding down its purchases of agency MBS with spreads projected to widen and yields/interest rates to rise as a result. Meanwhile, technicals were expected to deteriorate to some extent with the removal of such a large buyer. 

Some of the beginning-of-the-year projections were for spreads to widen around 30 basis points to 40 basis points following the Fed's exit; for the spread to 10-year notes to increase to 115 basis points; for the 30-year fixed mortgage rate to average 5.8%; and for the 10-year notes to average 4.03% in the fourth quarter.

Gross and net supply was estimated at $1.18 trillion and $318 billion, respectively, with demand predicted to more than offset supply.

Mortgages did better than projected as technicals stayed favorable overall. This was helped, to some extent, by the delinquency buybacks during the spring into early summer from the GSEs, which contributed to negative net issuance. At this time, gross issuance totals $1.2 trillion with net issuance for 2010 estimated at a negative $105 billion. 

On the demand side, banks bought $130 billion through November, according to Credit Suisse analysts. The overseas holdings decreased over $50 billion; money managers covered their underweights, while the Fed concluded their purchases with $139 billion over January through March. 

The Fed's exit did not have the impact that was expected.  In the month following its exit, the 30-year CC yield declined below 4.5% where it ended on March 31, while the spread to 10-year notes and swaps narrowed to the low to mid 60 basis points. 

In addition, as prepayments remained generally benign, the price of Barclays Capital's MBS Index rose to over $107 by early August from $103.71 as of December 31, 2009, with the OAD declining to under two-years from 3.7-years. 

As summer concluded and year-end approached, there were increased fears regarding prepayment risk based on discussions related to a government-related refinancing program,

The Fed finally decided to not only reinvest MBS paydowns into Treasurys but to buy an additional $600 billion through June 30, 2011. The headlines related to the former hit higher coupons in August, but as talked died down, they began to recover. The Fed actions, specifically, began to take a toll on the market in general because of increased concerns regarding the deficit, inflation, etc. MBS also began to suffer as the sector was hit with heavy convexity-related selling as Treasury yields backed up sharply. 

On Oct. 8, the 10-year note yield hit a low of 2.381% and has since backed up to the 3.50% area, which caused the duration of the MBS Index to lengthen to over 4.5-years.        

As 2010 winds down, MBS has had a relatively good year and certainly better than predicted.  In terms of mortgage rates, they averaged 4.69% year-to-date with a record low of 4.17% hit in mid-November and a high of 5.21% in early April in part on jitters associated with the Fed's exit. For all of 2010, the 10-year Treasury note never closed at 4% or above according to TradeWeb, with a yield high of 3.994% on April 5 and a low of 2.381% on Oct. 8.

As of yesterday's close, the spread to 10-year notes was 84 basis points with a range of 68 basis points to 88 basis points for the year, and 77 basis points versus swaps with a range of 65 basis points to 78 basis points. 

Year-to-date, the excess return on the Barclays MBS Index totals 197 basis points, with the sector outperforming corporates (174 basis pointss). The sector lagged ABS (233 basis points) and CMBS (1493 basis points). 

 2011 Preview

At this time, the 2011 projection for gross issuance is $1.2 trillion with net supply at around $370 billion. This is coming, in large part, from paydowns from the Fed/Treasury. 

Net demand is generally expected to meet the supply, which indicates increased spread volatility.

Barclays Capital analysts noted that the Fed/Treasury paydowns create an interesting dynamic for net supply: a decline in rates will lead to increased refinancing. This, in turn, increased net supply, while higher rates will reduce refinancing risk and net supply. 

"As a result, this supply dynamic should contribute to basis directionality into 2011," said analysts. 

Bank of America Merrill Lynch analysts expect the current coupon basis will end 2011 at wider levels with a target range of 115 basis points to 120 basis points over the 10-year note, although they expect spreads to narrow over the near-term before moving wider.

Meanwhile, Wells Fargo analysts also haves a target for the basis of 120 basis points/10-year notes in the first half of the year.

Mortgage rates are predicted to increase from an average of 4.4% in 4Q10 to 5.1% in 4Q11. This is expected to come with rates averaging 4.9%, which is slightly higher than 2010's average of 4.7%. 

Meanwhile, the 10-year note yield is projected to average 3.4% in the fourth quarter of next year from 2.8% this quarter, with yearly averages of 3.2% and 3.3% for 2010 and 2011, respectively.

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