MBS market participants continue to grapple with is what the Federal Reserve plans to do regarding its MBS purchase program.

Some analysts expect the Fed to slow the pace of its buying to extend its flexibility into 2010, partly as a weaning process for the market since this move would likely be less disruptive to the market.

Another reason that has been brought up is related to the uncertainty regarding how the GSEs will look like and how they will function in the future. The White House has said that would be forthcoming on this issue in February 2010. Based on the recent buying activity from the Fed, however, the government is currently on track to complete the program by the end of the year.

Deutsche Bank Securities analysts are among those who expect the Fed will slow their pace of purchases to avoid hitting the $1.25 trillion cap until "several months into 2010." They believe that, while spreads could still widen significantly into early 2010 under this policy, it would be less disruptive to the marketplace.

The MBS markets have been improving, and if these sectors continue to heal, Deutsche analysts believe this could help prevent a major widening of the basis from taking happening. They pointed out that CMO demand/supply has picked up strongly and that, "this is clear evidence of a gradual return of private sector demand for the agency MBS overall."

Still, there is uncertainty regarding the Fed's exit strategy, and, as such, they think it would be prudent to market weight the sector. They believe an overweight is too risky because of the substantial underperformance that would occur if the Fed completes its purchases by the end of 2009.

Deutsche analysts also do not favor an underweight because there is a third potential option for the Fed — extend the MBS purchase program into 2010 and increase the $1.25 trillion cap. This last option would be likely in the event of further deterioration in the housing market, an outlook that seems unlikely. Deutsche Bank's economists, for example, state that "it is increasingly clear to us that the housing sector has bottomed and that it will begin to modestly add to real GDP going forward."

They cite recent results in Housing Starts, Existing Home Sales, New Home Sales, and the July Senior Loan Officer Survey, which showed a lower percentage of banks tightening lending standards versus in previous surveys.

Analysts think the combination of Fed purchases of agency debt and MBS, and the improvement in credit conditions will allow housing credit to become more readily available in the coming months and help buoy housing demand even after the expiration of the first time homebuyer tax credit.

Barclays Capital analysts also believe a turnaround is approaching. In their latest Securitized Products Weekly, they now expect home prices to bottom at the end of 1Q10 with a sustained recovery (albeit slow and muted) starting at the beginning of 2Q10. They previously had predicted improvement not starting until the third quarter. In addition, they have revised their projected peak-to-trough drop in home prices to negative 36% from a previous projection of negative 40%.

What this all sums up to is a preference for an up in coupon bias into particularly 5.5s and 6s by Deutsche Bank analysts. If the Fed slows its pace of buying, as analysts expect, the impact will be especially felt in the lower coupons and will require private sector investors to pick up the several billion of new 4s, 4.5s and 5s, "and spreads would likely widen in those coupons as a result," analysts said.

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