Although U.S. bond yields spiked to 19-month highs last week as mortgage securities fell and swap spreads widened, rumors that the Federal Reserve will raise interest rates more than the expected quarter point on June 29 made at least one MBS portfolio manager react with a smile.

"If the Fed raises it more than the quarter point next week, I think it will be perceived strongly by the market, because it will be viewed as a one-time correction," said the source. "A change in 50-75 basis points is already priced into the market. So the real fear is that it would be 25, which would leave it murky as to what the Fed is going to do going forward."

While it is a foregone conclusion that the Fed will boost rates next week, investors still were not clear about whether there would be one or two more tightenings before the end of the year. All of this doubt and second-guessing led to a very negative week for mortgages, sources said.

According to market insiders, liquidity in mortgages last week was at the worst level seen this year. Although there was ample supply, sources said that a lot of dealers are cleaning up their balance sheets for the quarter's end, reflected by a distinct reluctance to bid on securities. This balance sheet reduction mode, coupled with fears of next week's announcement, hit mortgages hard.

The typical situation during a Treasury sell-off is that mortgages begin to tighten; however, insiders say that this was disturbingly not the case last week. Instead, mortgages were lagging the market, as mortgage collateral widened out - a highly unusual turn of events in a rising-rate environment.

"The option-adjusted spread on collateral is going over 100," said one MBS player. "Ginnies are all over 100, and most conventional markets are pretty close to 100, if not over."

On a swap-adjusted basis, however, the source noted that spreads are not that wide historically.

"It has been my opinion from the beginning that things will tighten in again," said the source. "The market will remain soft for awhile and then after next week's Fed meeting, we will have a much better market for July."

Though the average U.S. home mortgage rate fell to 7.63% last week, it remained near its highest level in more than two years, according to Freddie Mac.

Extension risk loomed on the horizon as an ongoing worry, as the high interest rates mean that there is less of a chance that homeowners will prepay, and money managers will hold onto their mortgage bonds longer.

But even with the higher rates, Fannie Mae announced that home sales will rise to a fourth-straight record this year as the economy continues to grow.

On the CMBS front, most market players were in New York City at the Fabozzi Commercial Real Estate and Securitization conference, so no new deals surfaced.

However, one CMBS portfolio manager noted that "trading has been sloppy," and he used this week to "trade up in liquidity and buy stronger deals."

"The market has just been so disjointed lately," he said. - AT

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