This week's activity was largely dictated by the Federal Open Market Committee (FOMC)statement released mid-day on Wednesday. The FOMC's statement effectively aligned the MBS stars: low rates, attractive carry and relative yield, along with increased odds of quantitative easing 3.

The two changes to the FOMC statement supporting this alignment were: (1) the Committee's decision that economic conditions "are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014"; and (2) additional language in its sentence referencing its securities holdings.

In the past the statements simply read: "The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate"; however, it was extended with "to promote a stronger economic recovery in a context of price stability."

This ignited down in coupon buying, particularly in 3.5%  coupons, but also 4.0s. The grab-a-thon were participated in by money managers, hedge funds, overseas investors, banks, insurance companies, servicers, and, of course, the Fed.

Prior to the FOMC on Tuesday evening was the State of the Union (SOTU) address, which also had a strong influence on trading activity. Heading into that, higher coupons, especially 4.5s and 5.0s, were pressured by selling from hedge funds and others on worries about what new or expanded initiatives the President would announce to help the housing market.

In his speech, President Obama said he was sending to Congress "a plan that gives every responsible homeowner the chance to save about $3,000 a year on their mortgage, by refinancing at historically low rates. No more red tape. No more runaround from the banks. A small fee on the largest financial institutions will ensure that it won’t add to the deficit and will give those banks that were rescued by taxpayers a chance to repay a deficit of trust."

With no details, higher coupons reacted adversely at first, but more rational thought afterwards on top of the cheapening brought investors back up-in-coupon by late Wednesday and more into Thursday and Friday's trading sessions.

Based on the President's remarks, MBS analysts believe the legislation would be targeted at helping non-agency loan borrowers to refinance into Federal Housing Administration mortgages.

This could probably be accomplished by using an expected settlement between banks and attorneys general regarding robo-signing toward writing down principal and refinancing them into FHA, suggested Nomura. In regards to HARP, since the recent changes have yet to be fully implemented and so have no track record to determine its success or not, as Credit Suisse analysts  believed any adjustments would not occur until this summer.

While higher coupons are likely to remain sensitive to the headlines, Credit Suisse analysts believed the sector was already pricing in a significant policy risk premium and they favored legging in on any meaningful cheapening.

Meanwhile, Bank of America Merrill Lynch analysts also viewed higher coupons' underperformance in response to the SOTU address "as an opportunity to add exposure to higher coupon MBS." 

Specifically, they noted that FNCL 5.0s currently provide attractive spread and minimal risk from HARP. Investors appeared to be of this mindset as well.

With the strong move down in coupon, the $1.6 billion per day average selling from mortgage bankers, mostly in 3.5s, was adequately absorbed. Supply was down from the previous week's $1.9 billion per day average. 

In its latest weekly recap for the period ending Jan. 25, the New York Federal Reserve reported gross and net MBS Agency purchases of $6.25 billion, or $1.25 billion per day on average. Over this same period, originator selling was about $8.5 billion which indicated coverage from the Fed of 73.5 percent of the supply. So far the Fed has bought $11.6 billion of its planned $25 billion for this four-week period which leaves $13.4 billion left to go, or about $1.1 billion per day.

In other mortgage-related activity, 15s lagged 30s as the flatter curve worked against intermediates; GN/FNs were lower; FG/FN were lower as Treasury BWICs consisted largely of Freddie paper; the 4.5 and 5.0 dollar roll was lower on increased prepayment risk, while specifieds were fairly active in the latter part of the week with investors seeking call protected paper.

Between the week's two significant news events, Tradeweb volume averaged 126% for the week through Thursday compared to 115% previously. Month-to-date excess return to Treasuries on Barclays Capital's MBS Index stood at +31 basis points, down from +40 on Monday before the SOTU and FOMC.

The 30-year current coupon yield declined to 2.92% from 2.97%, while the spread to 10-year notes was one basis point wider to +96. From last Friday's close through yesterday, 10-year Treasury notes had surged +27/32, the yield was down nearly 10 basis points to 1.933 percent, while the 2s10s curve was seven basis points flatter to 172.

Prepayment Outlook

Prepayment speeds currently are projected to slow around 2-3% on average for 30-year conventional and GNMAs and 15-year FNMAs in IFR Markets' sample.

In 30-year conventionals, 5.0% and lower coupons are expected to record larger percentage declines versus higher coupons with 6s and above seen flat to slightly faster on average from December.

The longer processing times associated with the credit impaired coupons is an influence on the fuller coupons.

Paydowns are estimated at $108 billion, currently matching month to date gross issuance. The January report will be released Feb 6.

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