Mortgages outperformed over the week based on expectations that the Federal Reserve will initiate QE3 at its September meeting and a drought in supply.

Through Thursday, excess return to Treasuries on Barclays MBS Index was +14 basis points which brought month-to-date performance to +27. Meanwhile, the current coupon spread to 10-year notes tightened five basis points to +95 as the yield declined to 2.47% from 2.50%.

Very favorable supply/demand technicals contributed to strengthening in MBS. Mortgage banker selling averaged just $1.6 billion per day from Friday through Thursday, against Fed buying which averaged $1.3 billion per day. Meanwhile, overseas, money managers, REITs, and hedge funds were all present and accounted for on a steady basis throughout the week - despite price levels and regardless of coupon.

The prospect that the Fed will initiate buying in MBS contributed to continued support down in coupon, even as Chairman Ben Bernanke indicated no specific easing actions ahead to help the economy and labor markets in his semiannual Monetary Policy Report to the Congress this week. His assessment of the economy and employment, however, was downbeat and this week there were more disappointing top tier economic reports (Retail Sales, LEI, Philly Fed) to further tip the balance towards the "to QE" side versus the "not to QE" side.

In fact, the QE3 probability crept back up to the mid-70s this week, according to Credit Suisse's "metric of MBS-implied QE3 probability," after dipping to the mid-60s from near 80% following release of the June FOMC minutes last week.

Based on Mr. Bernanke's testimony, Deutsche Bank's economists said they don't expect additional significant easing initiatives to come out of the upcoming July 31-August 1 FOMC meeting , adding that if the Fed did engage in another round of QE it would likely be at the mid-September meeting, after the Jackson Hole conference at the end of August.

Meanwhile, J.P. Morgan's economists assigned a greater than 50% chance the Fed will launch QE3 with MBS purchases in September. Likewise, Bank of America Merrill Lynch and BNP Paribas also anticipate action in September at the earliest as the Committee waits for more key economic news and the opportunity for further discussion that the Jackson Hole conference at the end of August should provide.

The higher HARP-eligible coupons also experienced buying interest on increased expectation that HARP 2.0 response is at or near its peak. For example, analysts with J.P. Morgan said they expect speeds will hover around these levels through the end of the year as some of the small-to-mid-sized lenders, not to mention Bank of America, are still ramping up their HARP programs.

With mortgage rates holding in record low territory, trading in specifieds remained active with strong demand from REITs, structured desks and others for call protected paper. Payups remained "well supported" and despite the levels, analysts with BNP Paribas believed payups "have room to move higher" based on a historical and even OAS analysis.

At mid-day on Friday, it appeared that lower coupon MBS were on track to set new highs again with 30-year FN 3.0 at 104-00, 3.5s at 106-05+ and 4.0s at 107-09. 10-year note yields were also at a record low 1.457%, while mortgage rates did set another historical low this week of 3.53%, according to Freddie Mac's survey, from 3.56% previously.

Overall, price levels and typical summer doldrums kept MBS volume based on Tradeweb's experience below normal at an average of 90% through the week through Thursday, essentially unchanged from last week.

ollowing anticipated BoA buyouts in July. Meanwhile, 2010 and 2011 3.5s and 4.0s are projected to increase another 10-20% in response to low rate levels.


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