Federal Reserve Chairman Ben Bernanke gave the markets a Valentine's Day gift with his upbeat tone on the economy and inflation at his semiannual report to the Senate Banking Committee. "So far, the incoming data have supported the view that the current stance of policy is likely to foster sustainable economic growth and a gradual ebbing of core inflation," he said. The Fed Chairman also reiterated the Federal Reserve's vigilance regarding inflation and that it would take action if required. He said that housing is a potential risk to the economic outlook, but noted there were tentative signs of stabilization such as the flattening in home sales figures recently, and some strength in mortgage application activity.
In addition to the Fed Chairman's comments, the economic data provided for additional market gains. Retail sales, for example, were slightly weaker than expected, initial claims were reported to be higher than the median, industrial production declined unexpectedly, capacity utilization backed off from inflationary levels, and the Philly Fed Survey reported deterioration to 0.6 in February compared with 8.3 in January and expectations of 5.0. Several components were weaker. In addition, the six-month outlook deteriorated for nearly all the categories.
Between the Fed Chairman's speech and the data, the 10-year Treasury rallied 13/32s with the yield declining 5.3 basis points to 4.731% through Valentine's Day from the previous Friday's close. Following the mostly weaker-than-expected data on Thursday, the 10-year Treasury had strengthened another 9/32s with the yield dipping to 4.69% at midday.
After a quiet start to the week as investors waited for the midweek data onslaught and the start of Bernanke's testimony, mortgage buying picked up as the market gained on Wednesday. Buyers outnumbered sellers by 3 to 1 with servicers and hedge funds actively moving down in coupon with 5.5s favored. Money managers were two-way, with some taking profits and also moving down in coupon into mostly 5.5s. Asian investors continued to have only a moderate presence. Last Thursday's morning activity, flows were modest and two-way, though the sector was lagging as volatility was higher on the rally and swap spreads were fractionally wider. Servicers were continuing to move down in coupon using the 6/5.5 swap, while real and fast money were more sidelined. Originator selling averaged about $1.5 billion per day, with supply mostly in 5.5% coupons and to a lesser extent in 6%s. Last week also included uneventful settlement in 15-year MBS and 30-year GNMAs with rolls mostly at carry.
Street mortgage outlook
This week market volume is expected to be down, as it is a big vacation week for certain areas of the country. In addition, Asian investors are away for their Golden Week celebrations. Mortgages are expected to see resistance from real money to further strengthening, especially as MBS are already seen as rich, with selloffs inspiring profit-taking activity.
Many Street analysts have come off their recent overweight recommendations and have turned more neutral or even underweight. JPMorgan Securities analysts, for example, moved to neutral from an overweight position because of expectations that near-term performance looked to be a "little bumpier." The next few weeks will see uncertainty regarding Asian investor activity; a correction in volatility toward firmer levels; the high level of dealer inventories; and tight nominal spreads.
UBS recommended that investors scale back to neutral versus swaps and wait for a better entry point. Analysts said that nominal spreads were very tight; that implied volatility is currently priced very close to actual volatility levels, while historically, implied volatility has been higher; and that foreign investors have been just marginal buyers at current levels. Analysts were also concerned that mortgages could cheapen marginally with Chinese investors out for the new year.
Deutsche Bank, meanwhile, downgraded to a slight underweight due to the expensive spread valuations, the narrowing of asset yields to funding, and negative convexity risks. Credit Suisse, however, was holding with its overweight because of expectations of lower volatility, a range-bound rate outlook and demand for yield. Deutsche analysts acknowledged, however, concerns with the technical backdrop of high dealer inventories and strong net issuance.
Economic data is a bit sparse in the Presidents Day week, with the highlight being Wednesday's CPI report. Other data out include leading indicators and minutes from the FOMC's January meeting on Wednesday, and initial claims and the Kansas City Federal Reserve Survey on Thursday. Other events of interest include two- and five-year Treasury note auctions on Wednesday and Thursday, respectively, and a few Federal Reserve speakers, including Governor Susan Bies and San Francisco Chief Janet Yellen.
Overseas mortgage investors have been the single largest source of demand over the last few years for non-agency MBS. In a report by Lehman Brothers, about 40% of net issuance has gone into overseas portfolios. While most of the holdings are believed to be in non-agency MBS, Lehman analysts said they have not separated holdings of ABS and CMBS from the available data. They also warned that the data could be overstated because of investments by hedge funds or CDOs that are based outside the U.S. but essentially operate like domestic institutions.
Lehman's report reviewed overseas demand by investor class: central banks versus private investors. They stated that the bulk of purchases in Treasurys and agency MBS is from central banks, while purchases of non-agencies and corporates are predominantly by private investors. While central bank portfolios have traditionally been in U.S. Treasurys, the trend is toward moving some of the holdings into the high-quality spread areas, such as agency MBS and debt versus corporates or ABS, analysts said.
Lehman attributes the growth of overseas holdings in MBS particularly to the growing U.S. current account deficit. Looking at historical data going back to 1985 of the U.S. rolling one-year account deficit and of the one-year change in overseas holdings of U.S. credit assets show a strong correlation between the two series, reported analysts. Lehman's economists estimate the current account deficit will stay around 6.5% of GDP over the next two years.
Refinancing activity increases,
Mortgage application activity increased 1.5% overall for the week ending Feb. 9 as mortgage rates declined modestly from recent highs. According to the Mortgage Bankers Association, the Refinance Index rose 4.5% to 2032, while the Purchase Index slipped just 1% to 401. Activity was in line with Countrywide Securities' experience for that week. A year ago, the indices stood at 1637 and 392, respectively, with 30-year fixed mortgage rates at similar levels.
As a percent of total applications, the refinance share held unchanged at 46.1% from the previous release. ARM share fell to 21.2% from 22.3%.
Mortgage rates increased just one to three basis points last week, according to Freddie Mac's weekly survey. In the 30-year fixed rate program, rates averaged 6.30% versus 6.28% in the previous week. A year ago, the 30-year rate was near current levels at 6.28%. Meanwhile, 15-year fixed mortgage rates rose just one basis point to 6.03%. On the adjustable side, five-year hybrid ARM rates were up two basis points to 6.01%, and one-year ARM rates increased to 5.52% from 5.49%.
Early indications show speeds slowing about 5% in February overall, in part on a lower day count: 19 versus 21. Partially offsetting this factor is an improvement in seasonals in February compared with January.
In March, speeds are expected to surge 20% on a three-day increase in the number of collection days as well as strengthening seasonals. Meanwhile, April's lower day count suggests speeds will slow about 5% from March's expected levels.
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