Two major themes that have been dominating the MBS market so far in 2012 are the third round of quantitative easing, or QE3, and refinancing activity associated with the changes to the Home Affordable Refinancing Program, dubbed HARP 2.0.
Both phenomena will continue to be influential factors on MBS trading and valuations across the entire coupon stack.
Particularly notable about conventional prepayment speeds in January was the absence of the impact of HARP 2.0 activity. Lenders began accepting applications on Dec. 1, and there was some anticipation that this would start filtering into prepayments.
While it was generally a no-show in terms of its effect on speeds, MBS analysts warned that the HARP factor will be adding to prepayment uncertainty in the coming months. Certainly capacity constraints at mortgage lenders continue to hinder HARP refinancing activity, especially with recent record low rate levels spurring refinancing among borrowers underlying the 4.0% through 4.5% coupons.
Morgan Stanley analysts suggested that with demand increasing from the better credits, it is likely that some lenders are not in a position to dedicate as much capacity to HARP refinancings.
The full impact of HARP 2.0 has generally been projected for spring and into early summer, as Fannie Mae's DU will not be updated for the HARP changes until March, while loans with LTVs greater than 125% cannot be placed into pools until June.
At this time, MBS analysts believe that there will be some influence on higher coupon speeds in February, becoming more pronounced in March. For example, 5.5s and higher coupons are projected to increase around 5% in the upcoming report and 10% in March, while holding flat in April.
Overall, speeds on 30-year MBS are currently projected to increase around 6%-7% on average in February from January, while March prepayments are expected to record an additional strengthening of 10%-15%.
The gain is a result of a combination of factors including seasonals, HARP and originators rushing to close loans before a 10-basis-point guarantee fee increase goes into effect on April 1. Meanwhile, April speeds should slow to around 2%-3% as the number of collection days drops to 20 from 22 in March.
QE3 Odds Roiled
Following the release of the Federal Open Market Committee (FOMC) statement in January, QE3 odds increased and were estimated to be around 40% by economists. Strengthening the odds was the extension of a low federal funds rate through late 2014 from a previously stated mid-2013 because of economic conditions. Additionally, the statement reiterated that the Federal Reserve would regularly examine the size and composition of its securities holdings. The Fed is also prepared to adjust those holdings as appropriate, adding that the goal is "to promote a stronger economic recovery in a context of price stability."
Release of the minutes from the January meeting, however, altered the market outlook, and the odds of another round of quantitative easing were adjusted downward. In the latest FOMC minutes, there was less support for the notion that additional accommodation from the Fed might be warranted.
Credit Suisse analysts calculated that market pricing of QE3 probability has scaled back to 25% from 40%. This was reflected by the underperformance in the lower end of the coupon stack as investors allowed 10-year note yields to back up all the way to 2.05% on Feb. 22 from the low 1.90% area in the prior midweek period before real money investors returned.
Meanwhile, Bank of America Merrill Lynch analysts believe that market's chance to what they had called "front run" the Fed has probably passed. Their analysis of MBS spreads has more to do with the market's view of QE3 timing instead of if it will happen. This sets up, they said, a potentially volatile trading pattern in the upcoming months. This, they said, will be subject to the following factors: economic releases, rates markets, and Fed speak. Economic growth momentum can also lead to lower probabilities getting priced.
According to BofA Merrill analysts, the current spread valuations would suggest a 60% probability for a third round of quantitative easing. For every 10 basis point move in spread, this translates into a projected 10% change in probability of QE3 expectations.
At this time, it appears the market has re-priced to the lower odds, and favorable supply/demand dynamics should be more evident, especially as the Fed continues to reinvest its paydowns to the tune of around a $1.3 billion per day average, started in October and covering a large percentage of mortgage banker selling.
Certainly technicals remain supportive for the sector, and "while it appears to be becoming less likely, the FOMC minutes by no means rule out QE3," Barclays Capital analysts said.
The probability of another round seems very dependent on the economy. If there is economic weakening over the next few months, Barclays analysts think that QE3 will then be seriously considered, while moderate growth will make it unnecessary.
Several economists still anticipate its implementation later this spring or early summer based on expectations that the current strength of the U.S. economy is not sustainable.