With the market facing an inverted U.S. Treasury yield curve, analysts from FTN Financial examined the implications for the MBS market of a more severe inversion over the next three months.
Analysts noted in a report that the U.S. Treasury curve has inverted since the Federal Reserve took the Fed Funds Target Rate up to 4.5%. Though analysts still believe that the curve will be steeper by the end of the year, they said it is wise to examine how to live through a short-term curve inversion in one's MBS portfolio.
The first thing that must be examined is whether a UST curve inversion will lead to a "spread" inversion. Analysts said that unlike the 2000 experience, the swap curve can invert with UST. They stated that swap spreads had begun to "disassociate" with the U.S. Treasury curve behavior long before the UST inversion of 2000. By contrast, analysts said the correlation between the swap curve and UST curve since July 2005 is 96% R-squared. This suggests that the market currently places less concern on the credit implications of swaps compared to 2000.
But there are other "spread" curves. There are agency spreads, various corporate spreads as well as different MBS/CMO spreads to be considered. In MBS, spread curves are far from inverted despite the UST curve being inverted as of the report's writing by five basis points 2s to 10s. A good picture of this "normal" spread curve is in CMOs. Though the CMO spread surface flattens out after seven years, it does not invert. Also, it is considerably upward sloping in the front end out to seven years. This would mean that 2s to 10s in UST space would need to invert by more than 50 basis points and the CMO spread surface would need to remain constant for there to be an actual inversion of the CMO curve. Analysts do not believe this is going to happen.
The hybrid ARM spread surface is another place that shows MBS resistance to inversion. Like the CMO surface, z-spreads on agency hybrid ARMs do not display any hint of inversion. Also, FTN analysts find it unlikely that par 30-year yields will fall below those of par 15-year yields. This would be the ultimate form of inversion in MBS, analysts said. (The yield spread between a hypothetical 30-year 5.75 and a 15-year 5.5 is currently about 35 basis points.) They added that there is too much convexity risk for a rational market to give a higher coupon to a par-priced 30-year asset versus a par-priced 15-year asset.
Long end outperforms
Analysts concluded that regardless of whether rates are rising or falling, in a further inversion the long end of the curve will outperform the short and intermediate parts of the curve. They rationalized running a three-month horizon as a short-term trade ahead of an expected curve normalization. Analysts expect securities that have a significant exposure to long-end partial duration buckets to experience the best performance in a more severe inverted curve scenario.
After projecting returns across their set of scenarios over a three-month period for a wide array of security types and durations, analysts ranked the securities according to their flattening profiles. They concluded that the flattening (inverted curve) performance is highly correlated to the duration of the security, meaning the longer the duration, the better performance in a flattener. They also observed that 30-year MBS will outperform 15-year MBS in a flattener. In shorter duration space, sequential CMOs and 15-year MBS outperform PACs and hybrid ARMs. In longer duration space, LCF Sequentials and long PACs have equally better flattening profiles versus deep discount 30-year MBS.
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