MBS trading activity could only be characterized as "lackluster" last week as the market held in range-bound as it waited for last Friday's July employment report. Investor flows were generally two-way, though down in coupon or into 15s was the more dominant direction. Volatility ticked slightly higher over the week on the number of key economic reports due out for the week, starting with the payrolls report, and into Tuesday's Federal Reserve meeting.

This is one reason 15s were favored last week, as it allowed investors to lower portfolio exposure to short volatility, but remain long MBS. Originator selling was light, averaging about $500 million per day, consisting primarily of 30-year 5.5% and 6.0% coupons. Last week also saw the start of roll-related trading. Traders were surprised at the early start; however, they attributed it to the FOMC meeting, the fact that certain players waited too long in July, and because the market had rallied recently. The 48-hour notification for 30-year conventional MBS begins this Tuesday.

Over the week, spreads on 30-year Fannie Mae 4.5s tightened two basis points, and were four basis points richer in 5s. Meanwhile, 5.5% and 6% coupons firmed one basis point and 6.5s were four basis points wider. In 15s, spreads were one to two basis points tighter in 4s and 4.5s, and flat to slightly wider in higher coupons. Analysts were primarily neutral last week, given the amount of economic data on the horizon and the increased risk of higher volatility.

Mortgage application activity holds steady

The Mortgage Bankers Association of America reported that overall mortgage application activity held steady for the week ending July 30. The Purchase Index rose 1.6% to 452, while the Refinancing Index slipped 3% to 1600. As a percentage of total application activity, refinancing fell to 35.8% from 36.8%. ARM share increased slightly to 33.5% from 33.3%.

Mortgage rates declined slightly more than expected for the week ending Aug. 6, according to Freddie Mac's weekly survey. The 30-year fixed-rate mortgage rate fell nine basis points to 5.99%. Also declining nine basis points were 15-year fixed rates to 5.40%, and one-year ARM rates to 4.08%. Looking ahead to this week's mortgage application report, JPMorgan Securities researchers say they expect the Refi Index to increase to the mid-1600 area, given the decline in rates.

More on hybrids and hedging changes

With the strong growth in the adjustable-rate market due to increasing mortgage rates, talk has picked up in the past several weeks about how this is going to impact the derivatives market. In a recent report from Bear Stearns, the implications are that options on five-year tenors could benefit relative to options on 10-year tenors and that six-month and one-year expiries could get a bid at the expense of five-year expiries.

Analysts note, for example, that three-by-one and five-by-one hybrids, which make up roughly 65% of the ARM market, have minimal 10-year exposure. In addition, ARMs also have better convexity and less volatility exposure than 30-year fixed-rate MBS. As a result, many mortgage players are increasing their ARM exposure and thus will have a lesser need for longer-dated options, researchers stated. They expect investors will focus more on options with six-month and one-year expiries, which hedge convexity, and also have some vega protection.

Traders have noticed an increase in buying of the six-month and one-year expiries on five-year tenors in recent weeks, according to Bear Stearns. Some of this buying could be ARM-related. Analysts also offered two additional arguments in support of the idea that hybrids will impact derivatives. One has to do with the GSEs - both Fannie Mae and Freddie Mac have been actively purchasing shorter-duration mortgage assets like hybrid ARMs lately. Also, given the tight spreads in fixed-rate MBS, GSE buying seems likely to continue.

The second reason offered has to do with servicers, as analysts said that since the proportion of ARMs securitized tends to be lower than that of fixed-rate mortgages, servicer hedging activity could be even more important than that of mortgage portfolios. Servicer focus on hedging of newly created ARMs servicing could significantly affect the derivatives market, analysts stated.

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