A week of predominantly housing reports, no Treasury coupon auctions, and very little Federal Reserve speak was supposed to provide a respite after the sharp sell-off last week via upbeat assessments of the economy in the Federal Open Market Committee (FOMC) statement.

That assessment pushed the 10-year note yields to nearly 2.30% from 2.03% at the start of the week prior. This is its highest level since late October.

The supposed respite was anything but. However, as investors remained in a risk-on frame of mind as the week began and the 10-year note yield pushed upward to almost 2.40% by Monday's close.

Outside of the increased mortgage banker supply that comes out in a sell-off, the magnitude of the backup and level significantly increased convexity-selling risks that are seen kicking in at over 2.40% 10-year note yield. As a result, lower coupons lagged sharply based on Monday's sell-off and curve steepening.

Treasury yields decreased over the remainder of the week to the lower 2.20s (10-year) by mid-day on Friday as risk aversion crept back on global growth concerns. Investor participation was widespread by account type. This included money managers, hedge funds, real money and REITs.

However, their enthusiasm was mixed as they were periodically opportunistic but sensitive to the increased convexity risks.

In other mortgage activity, dollar rolls were lower; 15s outperformed 30s into midweek on the curve steepness and extension risk than lagged as yields moved away from the highs, while GNMA/FNMAs were also higher into the first half of the week before turning lower.

Mortgage banker selling held near $2.0 billion per day with supply consisting of 3.5% and 4.0% coupons. Buying from the Fed, meanwhile, averaged $1.4 billion per day, or roughly 70% coverage of the supply, on net purchases of $7.0 billion for the week ending March 21.

In this current four-week period, it is estimated that they still have over $17 billion to put to work. This is equivalent to over $1.3 billion per day.

Overall, volume in MBS was slightly below normal at a 95% average for the week through Thursday compared to 113% last week. Month-to-date excess return on Barclays Capital's MBS Index was at +54 basis points through March 22, down from +59 through March 16.

The 30-year current coupon yield was slightly lower to 3.13% from 3.15%, while the spread to 10-year notes widened from +85 basis points to +91, which is at the tighter end of its recent rate and about in the middle year-to-date.

QE3 and Rates Outlook

While the economic news has been more positive than negative lately, QE3 is not yet off the table.

In a report from Royal Bank of Scotland's Macroeconomic Advisors regarding the probability of QE3, analysts said that if the economy evolves as outlined in the Fed's median FOMC forecast released in January, they assign a 25% probability to QE3 this year.

"However, given the risks around that forecast, the (unconditional) probability of QE3 is much higher, around 40%," RBS said. This is within the range of odds that other firms have offered on QE3 probability.

Barclays said that the chances have declined sharply and they do not expect it to occur this year. Meanwhile, Morgan Stanley's economists continued to expect either QE3 or extension of Operation Twist, though they acknowledge the call is more data dependent. They anticipate Fed speak to help clarify the Fed's thinking.

This certainly clouds the outlook for rates but in a research report, Barclays Capital analysts said they think a further sell-off such as what has occurred in the first half of March appears unlikely.

At this time, their rates analysts anticipate the 10-year note yield will hover around 2.25% in the second quarter and to be back near 2% by the fourth quarter. Factors they cited in support of their outlook are concerns related to fiscal tightening in 2013; the lack of risk free alternatives; and the Fed's expectations to hold rates low until 2014. Certainly such an outlook is favorable for MBS, especially amidst the continued strong supply/demand technicals.

Prepayment Outlook

Prepayment speeds are expected to increase 10%-15% on average in March in IFR Markets' sample. Lower coupons record the largest percent increases in part on a higher day count of 22 versus 20 in February, along with increased refinancing activity in response to record low mortgage rate levels. In addition, speeds will likely be impacted by a rush from servicers to close conventional loans before the 10 basis points increase in the guaranty-fee on April 1 to pay for the temporary extension of the payrolls-tax cut.

Overall, paydowns are predicted to jump to $132 billion from $111 billion in February with net issuance likely to be negative again. Month-to-date gross issuance is currently at $91 billion.

Looking ahead, speeds on average are currently seen slowing around 5% in April the day count declines to 20 days, and rise 5%-10% in May as the number of collection days increases by two to 22.

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