Mortgage outperformance continued last week due to several factors, including the release of the Fannie Mae Mega report, inversion of the swaps curve, low volatility and limited supply.

Flows were noted as two-way, with real money showing limited buying interest and better profit-taking activity, while fast money - including servicers - were better buyers. Their interest picked up sharply on Wednesday, along with dealers, with the release of the Fannie Mae Mega report showing that banks might have bought $10 billion in 5s. Asia also started to show more interest with buying noted in 5s through 6s. It appears originator selling has picked up a bit and is around its average of $1 billion per day.

Last week also saw the inversion of the swaps curve. In early trading on Thursday, the 2s/10s spread was minus-two basis points. In midweek comments from JPMorgan Securities analysts, they said this "benefits MBS as one of the few asset classes where the curve' remains upwardly sloped." They expect this to sustain the basis over the near term until supply begins to weigh or volatility ticks higher.

The outlook for mortgages remains interesting. Expectations are the sector should continue to hold firm if the market stays range-bound. Other positives include low volatility and limited supply. In the very near term, there is additional support anticipated from month-end index buyers. Barclays Capital analysts don't see a spread widening as a catalyst at this time, and with the market trading in a range, fears of duration selling are reduced.

Looking further out, JPMorgan analysts suggest the strong tightening in mortgages "is likely a prelude to a sharp reversal in the next couple of months." At the moment, however, they don't recommend a major underweight as they expect further tightening in mortgages. They are currently neutral on the basis.

Application activity mixed

Application activity was mixed for the week ending Feb. 17, according to the Mortgage Bankers Association. The Refinance Index declined 4% to 1,571 in response to higher rates while the Purchase Index rose 4.3% to 409.

Mortgage rates were little changed last week, according to Freddie Mac's primary mortgage market survey. Both 30- and 15-year fixed rates slipped two basis points to 6.26% and 5.89%, respectively. On the adjustable-rate side, 5/1 hybrid ARMs averaged 5.96% versus 5.95% previously, while one-year ARMs declined four basis points to 5.32%.

Freddie Mac's chief economist Frank Nothaft attributed the stable rates to the tame core inflation figures and market confidence in the Federal Reserve's ability to keep inflation low.

"Over the long term, we expect mortgage rates will bounce back and forth a bit, remaining near current levels," he said. "Based on applications for home purchases in November and December, we also expect that home sales will slow to a more traditional pace in January and February."

Based on the slight decline in mortgage rates, expectations were for application activity to have remained stable to slightly higher last week.

Prepayment outlook

February prepayments are expected to show moderate gains in speeds due to lower mortgage rates and higher refinancing activity over the period. Further gains are anticipated in March, helped by improving seasonals and a higher day count, while speeds in April are seen slowing due to four less collection days.

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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