Flows last week were dictated by the economic data and the curve reaction, particularly in relation to the favorable inflation report. The week started off quietly with some profit-taking noted from hedge funds and money managers. On Tuesday, the market took off, with strong buying from a variety of accounts in lower coupons as the market rallied on the better-than-expected CPI report. Wednesday, the up-in-coupon trade was preferred, with investors taking profits in lower coupons following the strong gains from the previous session as the market sold off.
In comments, JPMorgan Securities said it was myopic to go up-in-coupon solely based on the short-term carry ahead of a Fed rate increase. JPMorgan maintains a down-in-coupon bias and favors 30-year discounts over 15s. This is due in part to expectations that turnover activity will be higher than expected. As the week closed out, flows were light, but two-way. Originator selling averaged about $1 billion per day last week, with supply consisting primarily of 5.5% and 6.0% coupons.
With the bulk of economic data behind for the rest of June, the wait is on for the June 29-30 FOMC's meetings. As a result, activity going forward is expected to be relatively light. However, the light supply should keep mortgages firm. One trader also suggested that the slow decline in vols and a dealer community that is short and will cover on substantial weakness, also should result in continuing support for the sector.
UBS cautions, however, about the potential for increasing volatility as month end approaches due to (1) month end; (2) quarter end; (3) the FOMC; and (4) the Iraqi handover. Beyond the FOMC meeting, the mortgage outlook remains positive; hence, the neutral to positive recommendations by most firms remain. There is still time for the carry trade, and technicals remain very favorable.
Over the week, spreads on 30-year Fannie Mae 4.5s through 6s widened one basis point, while 6.5s were two basis points tighter. In 15s, spreads were two basis points weaker for 4s and 4.5s, and three basis points cheaper for 5s and 5.5s.
Mortgage application activity rises as rates hold steady
According to the Mortgage Bankers Association (MBA), mortgage application activity rose for the week ending June 11. The Purchase Index increased 4% to 450, while the Refi Index was up 8.5% to 1479. This was in line with Countrywide Securities' expectations and experience. As a percentage of total application activity, refinancings were 33.8% versus 32.6% in the previous week. ARM share activity was essentially unchanged at 34.7% versus 34.6%.
Mortgage rates were little changed for the week ending June 18, reported Freddie Mac. The 30-year fixed-rate mortgage rate moved up two basis points to 6.32%. The 15-year fixed-rate gained three basis points to 5.70%, while the one-year ARM rate slipped one basis point to 4.13%.
At current levels for refinancings and mortgage rates, speeds are expected to be down sharply by August. For example, speeds on 30-year Fannie Mae 2003 5s are predicted to be at 8% CPR by August versus 12% in May; 2003 5.5s at 11% from 23%; and 2003 6s at 18% from 35%.
UBS shows how to capitalize on out-of-favor pools
Loan characteristics that have provided good prepayment protection - low and moderate loan balance, investor properties, good geographics, etc. - are now out-of-favor with rates moving higher. UBS, however, says investors should consider this paper because (1) current pay-ups are cheap; and (2) the characteristics that provide prepayment protection also offer a certain amount of extension protection.
Regarding prepayment characteristics, prepayment protections in declining rate environments also make them attractive as rates rise, with the exception of New York loans. For example, UBS reviewed speeds on 1998-99 origination 6s and 6.5s through 2000 and found that speeds on higher loan balance collateral averaged 5.1% CPR, while the lower balance counterparts averaged 6.3% CPR. UBS analysts also said that low- and moderate-loan balance pools should pay more quickly when non-refinanceable because many of these borrowers are first-time homebuyers who will likely trade up when their circumstances allow.
Regarding the impact of geography, states like Florida and Texas consistently rank in the top one-third of states. Subprime loans also tend to prepay faster when out-of-the money. Investor properties, as well, tend to prepay faster as that borrower makes a business decision on the return of owning the home and renting it versus other investment alternatives, adds UBS. The bottom line, according to UBS, is that "every one of the characteristics that offers prepayment protection also offers extension protection, with the exception of New York pools."
Despite the above arguments in favor of these out-of-favor pools, UBS says investors are reluctant to buy the paper because it doesn't fit well into an index-based strategy in a bear market as pay-ups aren't likely to increase as rates rise, which limits the upside. To overcome this, UBS suggests investors write out-of-the-money calls on the 10-year swap. The total return profile from monetizing the convexity is very attractive, and allows a way for investors to pick up the specified collateral cheaply.
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