Some concerns remain in the MBS market that the strengthening economy will lead to a larger and more expedient uptick in interest rates. This poses big risks to mortgage investors and for the housing markets in general.

"The rapidity of some of the rate moves we've had recently has reinforced that concern," said Andrew Davidson, president of the Andrew Davidson & Co. Combined with this development, significant weakness in the economy is keeping interest rates where they are.

"There is still going to be tension between the two opposing forces of the current weakness of the Federal Reserve's actions to stimulate the economy and the fear associated with higher inflation and the growing economy," he added. Davidson noted that these are all playing out in election-year dynamics. All these factors combined have created the range that the mortgage market is currently trading in, which is characterized by a high level of range volatility and the fear that the market can break out of that range pretty aggressively, especially with the movement toward higher rates.

Davidson said that given all these factors, mortgages have cheapened up a little bit. However, during the latest interest rate move, there was a fair amount of selling in mortgages, but no panic selling occurred as most market participants were aware of the dynamics. Also, prepayment models have done a reasonably good job of forecasting prepayments under the various scenarios mentioned. The rate move was also not significant enough to alter market economics.

"I think the parameters are pretty clear to most investors," said Davidson. "Many of them are still trying to earn the spread by having some sort of a duration mismatch while being prepared to get out of that trade when the right time comes." He also noted that to the extent that some buysiders are in the yield curve trade and funding relatively shorter or not fully hedged, they face the risk of a rapid rate rise that could compel these investors to quickly sell.

Davidson believes that currently extension is imminent rather than call risk. He explained that the largest coupon in the mortgage market is now 5.5s, mostly those originated in 2003. For instance, this coupon is now priced at par 19. If rates rise, this coupon will trade at a discount. However, if rates fall, then they shorten and call risk becomes an issue. "And so we're really in a position that either of those risks can be a significant risk," said Davidson.

However, Davidson believes that the risk of a significant rate increase is more likely than a significant decrease, so he believes that the market should focus more on the extension side of the equation. "And, I think there are far more investors who are long duration - trying to pick up some of the yield from the steepness of the curve - so falling rates are not going to expose them to as much risk," Davidson explained. He added that an individual firm's position is going to determine its strategy. But overall, he believes that there is more extension risk in the market as a whole.

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