While the news of the week should have been the Federal Open Market Committee raising interest rates, mortgage market observers were more concerned with the U.S. Treasury Department's announcement that it would be repurchasing some of its debt, creating an inverted yield curve.

For the four-day trading period ending Feb. 2, spreads for the current coupon mortgage to the 10-year Treasury have widened 22 basis points, to 150 from 128. "Associated with a lot of buying of long Treasurys and selling the spread product, there's been a pretty quick blowout in spreads ranging across product areas from swaps to mortgages," said Art Frank, director of mortgage research at Nomura Securities. "And that kind of overwhelms in significance to anything that is going on with the Fed."

The inverted yield curve has caused a slight rally for mortgage-backed securities, which is ultimately affecting their supply and demand. "Nobody's traded an inversion for a long time," said one MBS trader, noting that this is the first inverted curve since 1991, which was a different kind of inversion. "This is kind of a funky environment, and what it means is, things like seasoned paper is worth a lot less because you're rolling up the curve."

"That by itself is going to widen yield spreads between corporates, mortgage-backeds and long Treasurys," added John Lonski, senior economist at Moody's Investors Service. "There's no escaping it. So you have an inverted yield curve for the Treasury bond market, but the same doesn't hold true for MBS nor for more traditional corporate bonds."

Robert Calhoun, co-director of research at fixed-income specialists Tattersall Advisory Group, added, "I think for mortgages, the bulk of the market is in the intermediate part of the curve, and is not as affecting the mortgage market nearly as much as it's affecting the corporate market, which has a lot of 30-year securities that are getting crushed relative to their benchmarks."

Frank said that the inversion is creating problems, which are affecting hedging positions. "It is affecting people's hedging decisions pretty significantly, that the right hedge vehicle agencies or swaps, or something other than on-the-run Treasurys," he said.

Calhoun added that being slightly off on hedging during these volatile times will have a much greater effect than normal. "Duration right now is not a big determinant of returns," he said. "It often depends if you hedge versus Treasurys, passthroughs, debentures or swaps because things have been so volatile."

In the near term, Frank is predicting that the Libor-OAS yield curve will be a more dominant curve than the Treasury curve, because mortgage rates are better correlated to long swap rates than long Treasury rates.

Where are the Commercial Banks?

Several market observers mentioned a key element that may be affecting supply and demand, especially as it relates to collateralized mortgage obligation paper: the money supply and its effect on banks.

Sources note that the Fed pumped a lot of money into the system last year to add liquidity for Y2K. After Y2K passed and was considered a non-event, the Fed began pulling money out. This all but sapped commercial bank demand, sources say.

"The fact that the money supply was immediately sucked out of the system after year-end, and now the Fed is officially tightening, has really decreased bank demand," commented one MBS trader.

As a result, CMOs have been rumored to be in heavy supply, mainly because it has become very tough for banks to buy securities and have an adequate funding spread at the same time. "So in order for them to make money, they have to make loans and pull in some of the fees as well as the interest rates that they get," the trader added. "The fact is, the banks are savvy enough with their own deposit base to understand what's hot money and what's not."

As much as $2.5 billion in short CMO paper has been suggested to be lying around, but while market observers do not consider this fact to be the least bit surprising, they generally don't believe the FOMC decision will have any effect on the demand for CMO paper. The reason for this is the prospect of another increase in March.

"However, I think CMOs are starting to look very attractive versus collateral, especially short and intermediate-structured product," another trader noted.

As to whether the rumored $2.5 billion figure sounds accurate, the trader noted that there were probably only five deals conducted last year, of approximately $750 million each. If two-thirds of those deals end up being short paper, then it comes out to approximately $2.2 billion. "It's in the right ballpark," he said.

The basic problem observers are seeing is that an absence of commercial banks has caused the buildup. Coupled with the Fed taking back extra funding due to a non-eventful Y2K, "they're not going to buy securities with money they think is going to be pulled out of the system," the trader said.

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