With the summer doldrums in full swing and very limited economic news or other key events, this week's trading influences in the mortgage sector were left primarily to July prepayments and Class A – 30-year FNMAs and FHLMC Golds – pool allocations.
Speeds on moderately seasoned conventional 3.5s through 4.5s were faster than expected as borrowers responded to record low mortgage rate levels in June, while the higher coupons eligible for the Home Affordable Refinance Program (HARP) rose just 2%-3%, which was in line with expectations.
Meanwhile, GNMAs prepaid slower than expected as capacity constraints at the mortgage bankers apparently limited the number of closings on pre-June 2009 borrowers that were eligible for reduced mortgage insurance premiums. Delinquency buyouts from Bank of America were less than expected as well, but focused primarily in 5.5s as was anticipated.
Speaking of BofA buyouts, more are likely in the August report as the delinquency rate remains above GNMA's 5% threshold. Deutsche Bank Securities MBS analysts noted in their MBSTrader brief that delinquencies are across the coupon stack, and by loan count on 5.0s and higher they calculated that 65% is in 5.0s, 25% is in 5.5s, and 10% in higher coupons. They said that as buying out all the super premium coupon loans would barely take the delinquency rate below 5.0%, the 5.0 and 5.5 cohorts "are in the crosshairs." They warned that "for holders of high coupon GNMA, caution is the watch word."
While the initial reaction to the prepayment reports was as expected with higher coupons outperforming lower ones, which was aided as well by a steeper yield curve, price and spread weakness as Treasurys sold off sharply over mid-week drew in the ever opportunistic real and fast money given the favorable technicals, carry, and strong quantitative easing prospects despite expectations of further increases in prepayments in August.
Over Tuesday through Thursday, 10-year notes lost close to 7/8 of a point with the yield backing up to nearly 1.70% on a combination of $72 billion in 3s/10s/30s being auctioned, along with a modest appetite for risk as equity investors globally anticipate central bank actions over the near term horizon. Despite the sell-off, supply was surprisingly well-behaved and averaged just slightly above normal at $2.3 billion per day.
Meanwhile, the Federal Reserve held to a steady $1.3 billion daily average pace on net and thus provided coverage of close to 60% of the supply. Their buying in 30-year 3.5% coupons ticked up to 38.5% from 33.1%, while 3.0s lowered to 51.5% from 55.4% as it tracked the trend in supply. Heading into August, supply consisted largely of 3.0s as rates dropped in response to risk aversion and anticipation that the Federal Open Market Committee and European Central Bank would announce changes to monetary policy. However, some better than expected data – particularly the employment report, as well as no changes currently to monetary policy pushed rates higher with 3.5s now making up the largest percentage of originator selling.
In regards to upcoming Fed buying, it is anticipated to increase to a $1.5 billion/day average beginning next week as July paydowns from agency MBS and debentures are projected to have totaled $30 billion, up from $27 billion in the four week period concluding today, and this should add to the already strong demand technicals. The New York Federal Reserve Bank will announce on Aug. 13 what it estimates it will buy over the four-week period that begins on the same day.
Following the prepay report, most rolls weakened with the exception of FN 3.5s and the roll on that coupon strengthened further into 48-hour day on Thursday to a 10 bid, while 5.5s also gained.
Treasurys were rallying moderately on Friday into mid-day on a combination of no supply with the coupon auctions completed and with another round (2s/5s/7s) not until the last week of August, as well as, on disappointing data from China that turned investors more risk averse. The 10-year note yield was at roughly 1.65%, while mortgage spreads were flat to wider with fuller coupons lagging the most on a flatter yield curve. Volume was light as was supply.
In other mortgage related activity over the week, trading in specifieds appeared less active than in previous weeks as a result of 48-hour day. Of note, however, was some cheapening in payups on 3.5%s due to the strengthening dollar roll.
The 15s mostly outperformed 30s on a combination of a more favorable prepayment report as well as a steeper yield curve, while GNMA/FNMAs were higher in production coupons and lower on 4.5s and above due to call risk related to reduced mortgage insurance premiums for pre-June 2009 borrowers and BofA buyouts.
Tradeweb reported MBS volume was slightly below normal at a 94% average for the week through Thursday compared to 111% last week. Over this same period, mortgages outperformed Treasurys by 10 basis points (Barclays MBS Index) with month-to-date performance at 22 basis points. The 30-year current coupon yield rose to 2.50% from 2.48% with the spread to 10-year notes tightening nine basis points to +82.
Looking ahead to next week, there are several important reports released including retail sales, Empire State, Philadelphia Fed, and PPI/CPI that investors may take note of in gauging QE3 prospects for September. At the moment, it remains fairly high at 77% according to Credit Suisse's metric. As MBS valuations reflect the high odds, strong prints could add to uncertainty of whether they will act as soon as September and investors may require some additional spread widening.
