Federal Reserve Chairman Ben Bernanke offered some calming words for the mortgage-backed securities market in his semiannual Humphrey-Hawkins testimony before Congress on Tuesday and Wednesday.
As a result, the market’s performance became somewhat more directional with interest rates (tightening in rallies, lagging in sell-offs) compared to underperforming in both rallies and sell-offs as they mostly had been since release of the minutes of the recent Federal Open Market Committee Meeting last week.
In his Monetary Policy Report, Bernanke noted the FOMC has indicated it would continue its asset purchases until it sees substantial improvement in the outlook for the labor market, which he said remained generally weak with the unemployment rate above its longer-run normal level. Bernanke also said that the benefits of the Fed’s monetary policy to promote a stronger economic recovery outweighed the potential risks at this time.
Despite these assurances, flows in 30-year 3.0s remained mixed over the course of his testimony. Also weighing on 3s: a pickup in mortgage banker supply as yields declined on increased risk aversion related primarily to uncertainty in the euro zone following elections in Italy where no one party gained a governing majority. Regarding the latter, selling from originators averaged $2.7 billion per day with supply increasing over the course of the week, from $2.0 billion to over $3.0 billion with over 60% in 30-year 3.0s.
While the Fed is expected to continue buying MBS at a pace of $40 billion per month and reinvesting paydowns back into MBS, real money investors seemed to continue to look well ahead to the potential impact on spreads and prices when the Fed eventually tightens monetary policy.
Deutsche Bank MBS analysts said in weekly research that, at the higher rate levels envisioned by the Fed when it begins to unwind its portfolio, they estimated their selling would widen option-adjusted spreads on 30-year pass-throughs by about 50 basis points with the price dropping by 3-1/2 points. They said this future risk should be impacting pricing today and "The more the Fed will potentially own of a coupon, the more risk on exit." This likely explains the generally mixed flows in 3.0s and better support up in coupon.
Speaking at the Senate hearing, Bernanke said that when it came time for the Fed to unwind its portfolio it would "sell slowly with lots of notice." Asked by the House Financial Services Committee about when the unemployment rate might contract to 6% from 7.9% currently, he said a reasonable guess would be around 2016.
While the Fed’s asset purchases are not expected to continue much beyond the end of this year, Bernanke’s answers suggested that sales are not a risk for a few more years. In recent research, Bank of America Merrill Lynch MBS analysts said they believed sales were not likely until 2016 and that the process would be a slow and gradual one.
There was better support showing on Thursday in 30-year 3.0s on good month-end index buying, as well as, on news of more capital raising by real estate investment trusts (REITs). Barclays’ MBS Index was projected to extend a lengthy 0.17-year on Mar. 1 from an average monthly extension of 0.08-year in February. Meanwhile, American Capital announced it would sell 50 million shares and at 6 times to 8 times leverage; this calculates to between $10 and $12 billion in potential MBS buying ahead.
Better support from REITs was also good news as money managers have been in the process of reducing their overweights to neutral. JPMorgan calculated that money managers hold 38% of their holdings in MBS, versus a neutral weight of 25%; the bank also estimated that money managers still have $215 billion more to sell. Assuming the Fed keeps up its pace of buying through year-end, the supply from money managers will be absorbed; however, temporary technical imbalances with supply overwhelming demand will keep spreads from tightening noticeably.
Speaking of Fed purchases, the latest report from the New York Fed showed gross and net buying in MBS totaled $18.8 billion for the week ending Feb. 27, or $3.8 billion per day on average, which is where it has been for the past three weeks.
Into early afternoon on Friday, flows were mixed with MBS lagging as risk aversion strengthened on weak economic news and apprehension about the potential impact from automatic spending cuts scheduled to take effect around midnight tonight. Also adversely impacting MBS performance was dollar roll weakness.
In other mortgage-related activity, specified pool trading was more balanced this week from the better selling of the past few weeks. Lower rates amidst lower payups and higher yields perked up interest for call-protected pools from banks and money managers and collateralized mortgage obligation desks. Sizeable originator bid lists will be coming over the next few days with Class A (30-year FNMA and FHLMC) 48-hour day next Friday; this should keep payups from strengthening. Fifteens lagged 30s as the 2s-10s yield curve flattened to the mid/lower 160 basis points from 171 basis points last Friday, while GN/FN were higher.
For the week through Thursday, volume in MBS averaged 97%, compared with 83% last week according to Tradeweb's experience. Excess return to Treasuries on Barclays’ MBS Index was negative 6 basis points over Monday through Thursday, and negative 8 basis points for February with the YTD performance at negative 13 basis points. The 30-year current coupon yield declined 8.3 basis points over the week to 2.533%, with the spread holding at 65 basis points from last Friday and wider by nearly 8 basis points from the end of January.