JPMorgan Securities analysts looked at the shift in MBS sponsorship in a recent report. With mortgage OAS roughly five basis points wider than levels observed in April, the sector is now not so fundamentally rich that it would derail the participation of relative value investors such as hedge funds, money managers, etc. Greater participation by these investors would mean a shift from an environment where net purchases were almost dominated by banks and Asia. The consequence of this is twofold. The first is volatility could be bid somewhat higher as these investors have a greater propensity to hedge with volatility, and swap spreads could go wider as they hedge the duration. The impact of this activity could be seen in the widening of both swap spreads and mortgage spreads recently, analysts noted.
Longer-dated implied volatility has been a major driver of mortgage performance, as the sector has become increasingly efficient at reflecting volatility changes. Since the end of last year, the implied volatility on 3x7 swaptions - which are one of the structures most correlated to 30-year fixed-rate MBS valuations - has fallen by nearly a full basis point per day, before actually recently stabilizing. JPMorgan had argued that a further decline in volatility would lead to a narrowing in nominal spreads in mortgages. But, as the purchases of vega could offset the supply of vega from range accrual notes recently, the firm's derivative strategists are shifting to a neutral view on longer-dated volatility from being negative.
Asia and banks sidelined
However, analysts said that demand from banks and Asian investors will be staying limited over the next one to two quarters.
Asia has been significantly under-invested in the U.S. mortgage sector, and is looking for signs of a turn in Federal Reserve action before coming back to the market, JPMorgan explained. This is specifically the case for Japan, while Taiwanese demand could be boosted by a rise in the U.S. dollar limit on their investment portfolios, which currently is 35% and potentially going to 50% by year-end. For now, however, analysts expect unchanged levels of demand.
In terms of bank demand, unrealized losses in AFS portfolios have hit a new high of $22 billion and are also approaching their previous highs on a percentage basis. This figure has been very correlated with rates as expected, and rates would need to be about 100 basis points less before their losses were removed, analysts said.
Analysts added that there are two main branches of this regression with various slopes, one representing the 2000 sell-off and the other representing the 2005 to 2006 sell-off. This can be explained mostly by the growth in their securities portfolios over the past five years. Deposit growth has also been modestly positive year-over-year, and a lagging deposit rate will make up for the flattening of the curve that happened recently, for the next quarter or two.
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