The Federal Open Market Committee (FOMC) announced yesterday it would slow the pace of its plan to purchase $1.25 trillion in MBS, and extend the program through the end of 1Q10. The FOMC is doing this to, "promote a smooth transition in markets."
Barclays Capital analysts reported late yesterday that they continue to favor being long the basis over the near-term as they believe the Fed will reduce its pace marginally.
"Assuming a steady decline in the rate of purchase, the Fed would have to reduce it only 15-20% a month to reach the total," Barclays analysts said, "or down to $20 billion per week during the next 4-5 weeks." At the same time, supply is running at around $10 billion per week at the most currently. "With supply still muted, technicals should favor a long basis position," they said.
Analysts also noted that the extension of the program removes the risk of a spread blow-out, postpones the risk of money managers exiting en masse ahead of the Fed's exit, and should keep realized vol contained for a longer period. The latter along with a strong roll should also encourage investors to earn mortgage carry for a while longer, they said.
Credit Suisse analysts calculated that the MBS basis to 10-year Treasurys should eventually widen to around 115 basis points over a gradual three- to four-month process from 86 basis points currently.
Analysts said that while it's possible that spreads will peak at a higher level, they anticipate the basis will settle tighter than the long term average of 120 basis points, given the projected high percentage held by the government sources. They recommended shorting the MBS against Treasurys and riding the slowdown in Fed purchases.
Meanwhile, National Mortgage News reported that the market reacted less to the Federal Reserve's plan to continue its purchases of agency MBS and debt through the first quarter of 2010 than it did to concerns about a somewhat related shift in index use by at least one investor on Sept. 23 that was seen as having implications for the secondary market that drives rates.
Art Frank, director and head of mortgage-backed securities at Deutsche Bank Securities said the market was concerned that one investor's shift to the use of a float-adjusted index that excludes published Fed purchases of MBS could be a trend, and if larger investors were to make such a move some of the lower coupons — which the Fed buys — could be affected negatively.
However, investors could alternatively choose to remain with the current index that includes Fed MBS buys as it would naturally phase out their influence as those purchases became less influential in the market. MBS widened earlier in the day on news of the index shift concern and widened a little more when the Fed statement disclosing its plan came out.
But subsequent buying done largely by leveraged investors had left spreads only slightly wider to swaps and even less wide to Treasurys as of late on Sept. 23.