Last week saw moderate two-way flows as the 10-year Treasury yield slipped below 4%. Early week flows consisted of up-in-coupon when the yield held above 4 %, but down-in-coupon picked up later on some convexity buying when the yield held below 4%. In addition, the 15-year sector saw better support on a combination of recent cheapening as well as increased volatility concerns that would impact 30s more.
The major talk, of course, has related to hedging needs and the impact on the market. For the most part, it has been a non-event this time around, though risks are seen at the 3.90% threshold on the 10-year. In comments from Banc of America Securities (BofA) last week, analysts believe concern regarding mortgages' impact on the market if the 10-year yield moves near 4% is "overwrought." While a 3.90% yield creates a refi incentive for the massive 5.50% coupon, analysts expect "the rise in activity may be more of a business boon to mortgage originators than a panic for mortgage servicers." This is due to falling implied volatility in the rates market that suggests to BofA that the market is not at a panic 4% from the perspective of the options market.
"A combination of reduced hedging needs, especially from mortgage originators, and increased hedging discipline has alleviated overall convexity risk in the market," Lehman Brothers said in a research report. If rates do rally enough, duration buying would be a reasonably smooth and orderly process, analysts stated.
Bear Stearns noted that the 4% level is important because it pushes the massive 5.50% coupon to the edge of their minimum 40 basis points refinancing threshold. Below 4%, refinancing could rise significantly. Also, at sub-4%, that duration shortens significantly, and the negative convexity exposure of the MBS market increases, analysts stated. Bear Stearns believes the market is ignoring the possibility of rates falling enough to cause heavy refinancing in 5.5s. "This seems dangerous at current rate levels," analysts wrote, and recommended investors buy convexity protection against a rally.
UBS, meanwhile, is not too concerned about convexity issues as rates are still a good ways away from considerable refinancing activity. On top of that, supply remained limited - averaging between $1 billion and $1.5 billion per day.
Over the past week, spreads were flat to one basis point wider in 30-year Fannie Mae 4.5s through 6.5s, with the exception of 6s which were two basis points tighter. Of note is increasing support recently in Fannie Mae 6.5s. JPMorgan Securities said the coupon is seeing strong buying from a large money manager and that it is seen continuing through the end of the month, adding that the Street is now short the coupon. In 15s, spreads were three to four basis points weaker.
Application activity increases slightly as mortgage rates slip
Application activity increased modestly for the week ending Sept. 17. The Purchase Index was little changed at 457 from 456 previously, according to the Mortgage Bankers Association (MBA). Purchase activity holds steady, but is expected to cool as the fall sets. Meanwhile, the Refi Index rose 4% to 2053. On an unadjusted basis, purchases jumped 24% and refinancings surged 30%. As a percentage of total application activity, refinancings were 44.50% versus 43.20%. ARM share held virtually unchanged at 33.10% versus 33% previously.
Mortgage rates declined, as expected, for the week ending Sept. 24. Freddie Mac reported that the 30-year fixed rate fell five basis points from last week to 5.70%. Rates remain at early April lows. The low for the year - 5.38% - occurred in mid-March. The 15-year fixed rate mortgage rate came in at 5.10% versus 5.13% previously. Lastly, the one-year ARM rate also slipped three basis points to 4%.
At current rate levels, Lehman anticipates the Refi Index to be in the low-to-mid 2000s this week. Analysts added that it would take about a 25 basis points rally to put the Refi Index into the low-3000s. However, Bear Stearns says that if the 10-year yield falls below 4% and holds for at least a week, the Refi Index would likely approach 3000. It would take mortgage rates dropping to 5.40%, or around 3.75% yield on the 10-year, for the Refi Index to kick up to the 4500 to 5000 area. At this level, approximately 65% of the mortgage universe would be refinanceable, according to calculations. Currently, about 37% of the market is considered refinanceable.
Prepayment outlook
Given application activity over the past two months or so, prepayment speeds are expected to show moderate increases - particularly in 5.5s and 6s- over the next several reports. Speeds on Ginnie Maes are predicted to continue to prepay faster than their conventional counterparts primarily due to increasing delinquencies. As far as how the recent hurricanes may impact Ginnies, JPMorgan says it should be marginal - at most 1% CPR - on all pools in the next three to six months.
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