Investors appeared very much to play the range this final week of June - and a tight range it is.  In the last half of June,  the 30-year current coupon spread to 10-year notes has ranged between 106 and 109 basis points.

At lower prices and supply-induced widening, a broad range of investors appeared including banks, REITs, overseas buyers, money managers, and hedge funds, while higher prices and spreads firming to the tighter end led to active profit taking, particularly from money managers. Flows were primarily concentrated in 3.0% and 3.5% coupons, where the Federal Reserve and Liquidity are located.

The strong supply/demand technicals, favorable carry and potential for additional QE are the reasons for the narrow range. The catalysts for adjusting the range are primarily related to Europe and domestic data - and headlines on both this week did not alter the economic growth outlook or QE3 prospects. On the latter, the next key item is the June Employment Report on July 6 which the consensus call at the moment is an unimpressive +89k in jobs creation. In terms of Europe, a summit this week in Brussels resulted in an agreement among European Union (EU) leaders to help resolve the debt crisis; however, various details regarding implementation still need to be worked out.   

  1. Activity up in coupon was two-way in conventionals. While Home Affordable Refinance Program  (HARP) prepayment risk remains a concern, the decline in conventional refinancing activity in the past couple of weeks is some relief.  Since the week ending June 15, the Mortgage Bankers Association's (MBA) Conventional Refinance Index has declined 18%.  While the MBA did not mention HARP activity in its most recent mortgage application survey, in the prior one for the week ending June 15 it noted the HARP share of refinancing activity dropped to 20% from 28%. 

Meanwhile, higher coupon GNMA/FNMA swaps remained pressured by selling in fuller coupon GNMAs with investors (especially overseas) moving down in coupon as prepayments are expected to increase noticeably in July and into August due to the recent reduction in mortgage insurance premiums for pre-June 2009 borrowers. The MBA's Government Refinance Index did ease back after surging 121% in the June 15 week to a record high 8872. However, it remained elevated at 6786. Credit Suisse analysts said that recent research that if the index drops to 3000, August prepayments on mortgage insurance premium reduction-eligible GNMA cohorts should be similar to the July increases. If it remains elevated in coming weeks, "it will imply even higher August speeds on these cohorts," they said.

In other activity, trading in specified pools was active with continued demand for call protected paper such as loan balance, high LTV (CR/U9) pools, and MHA. In 15s, banks and REITs were noted buying in 2.5% and 3.0s versus Dwarf 3.5s. 15s outperformed 30s early in the week, lagged in the mid-part, and recovered on Friday as a result of the sharp steepening in the yield curve following the EU agreement which encouraged the risk on trade.

Mortgage banker supply averaged $2.0 billion per day, down from $2.5 billion last week. Selling consisted largely of 30-year 3.5%s. The Fed, meanwhile, held to a daily average of $1.2 billion which equated to 60% coverage of the supply. MBS volume was below normal at 88% for the week through Thursday, based on Tradeweb's experience, compared to 101% previously.  Barclays Capital's MBS Index for the past four days was -14 basis points which brought month-to-date excess return to Treasurys to +16. Over this same period, the 30-year current coupon yield declined to 2.66% from 2.73% with the spread to the 10-year note at +109 from +106.  At the end of May, the yield was 2.705% and spread +114.

Prepayment Outlook

Speeds on 15-year FNMAs and 30-year conventional MBS are predicted to increase around 5% on average in June and again in July. 3.5% and moderately seasoned 4.0% and 4.5% coupons will see the largest percentage gains at 10-20+% as the underlying credit-eligible borrowers responded to the successive lows in mortgage rates. Meanwhile, speeds on the higher coupon HARP candidates are predicted to see further strengthening in June at +3-4%. Meanwhile, GNMA I 3.5% through 5.5% coupons are expected to increase around 5% in June and jump by 15% in July. Paydowns are estimated at ~$121 billion, while gross supply totaled $134 billion in June. 

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