With Federal Reserve Chairman Alan Greenspan's Congressional testimony yielding nothing especially new, it appeared that last week would turn out to be a yawn. China, of course, changed that. The China headline news - regarding pegging its currency to a basket of currencies rather than just the U.S. dollar - jolted the market on fears that the change will lead to reduced Chinese investment in U.S. dollar assets. Before this, the mortgage tone had been supportive with focus on moving up in coupon, particularly into 30-year 5.5s by servicers and hedge funds, and into 6s by relative value investors. On Thursday morning, as the China revaluation news was reported, mortgages experienced strong selling from originators and fast money especially in 4.5s through 5.5s - over $3 billion combined as of mid-day.
Analysts last week were mostly neutral to positive on the mortgage sector given current yield levels and expectations of a decline in volatility, with preference to move up in coupon while further spread tightening is anticipated to be limited. The longer-term outlook is less certain. On the supply side, JPMorgan Securities estimates 30-year agency MBS is on track to increase its market share by $100 billion per year. At this pace, analysts say the 30-year sector will be almost evenly distributed across 2003, 2004 and 2005 originations. At the same time, 15-year issuance is looking to drop by $60 billion per year. While supply is increasing in 30s, decreasing demand is a concern. Bank support has been concentrated, the GSEs' outlook is very limited, and overseas buying has been less supportive than anticipated as a result of the tight spreads in the sector.
Application activity holds firm despite higher rates
The Mortgage Bankers Association reported that mortgage application activity increased slightly for the week ending July 15. The Purchase Index was essentially unchanged at 488.7 versus 489, while the Refinance Index rose 2.5% to 2618 on a pick up in activity following the Independence Day break.
As a percentage of total application activity, refinancings were 45.7%, up slightly from the previous report of 45.1%. ARM share also increased to 28.5% from 27.9%. By dollar volume, ARM share is a still healthy 42.2%, up from 41.5% previously, though down from a high of 52% for the week ending March 25.
Freddie Mac reported higher mortgage rates in response to the recent backup in yields. For the week ending July 22, the 30-year fixed rate mortgage rate averaged 5.73%, up from the previous week's report of 5.66%. Rates are up 20 basis points from their recent low of 5.53% for the week ending July 1, and back to similar levels reported in early/mid-May. Meanwhile, the 15-year fixed rate also increased seven basis points to 5.32%; 5/1 hybrid ARMs were up 11 basis points to 5.26%; and the one-year ARM rate averaged 4.42% versus 4.39% previously. With mortgage rates higher, refinancing activity is expected to decline to the 2400 area in this week's release.
Prepayment outlook
Currently, consensus calls for July prepayments to increase around 5% overall. The modest increase is due to a lower day count compared to June - 20 versus 22 - which partially offsets stronger refinancing activity in late June through early July, as mortgage rates declined. August sees slightly higher percentage increases in speeds versus July as more collection days, 23, offset declining refinancing activity. Looking out to September, speeds are projected to slow around 10% for FNMAs and 5% for GNMAs due to a lower day count, declining seasonal factors and expectations of lower refinancing activity.
Regarding the current prepayment environment, Countrywide Securities notes that out-of-the-money and at-the-money speeds have benefited from fixed-to-ARM refinancings. They state this activity has held fairly stable despite the flattening in the yield curve. In order for this activity to dry up, two things would need to occur, according to Countrywide. The curve must flatten to the point where it would be severely inverted and the pay-option refinancing alernatives should disappear. Meanwhile, analysts note in-the-money speeds have been relatively slow as there is little incentive to refinance into another fixed rate loan at current levels.
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