The Federal Open Market Committee provided the biggest surprise last week by cutting the Fed Funds rate 50 basis points, instead of the expected 25 basis points. It was a unanimous decision related to concerns about the economy's growth. Odds are currently high that the Fed will cut another 25 basis points at the end of October.
However, Bear Stearns economists think it is unlikely that the Fed will cut again this year as they anticipate moderate growth in the economy. The economists also expect the Fed will be forced to reverse the cut in 2008 based on increasing inflation pressures. Deutsche Bank Securities analysts, on the other hand, expect an "insurance" ease of 25 basis points at the October meeting as they anticipate that inflation pressures will continue to moderate in the near term. They also believe the Fed would take rates lower in the event that growth slows substantially below 2% or if the unemployment rate creeps up to 5%.
MBS participants were hoping for a 50 basis point cut, as anything less would likely result in a negative market reaction. After quiet, two-way flows ahead of the Fed's move, flows surged with heavy buying after the news.
From the FOMC's announcement through Wednesday, buyers were said to have outnumbered sellers by 10 to one. A wide range of investors included overseas buyers, and the greatest interest focused on 5.5% coupons.
Money managers and hedge funds took some profits, but that followed a press release from the Office of Federal Housing Enterprise Oversight announcing some adjustments to the GSEs' portfolio caps and growth. One change in particular would allow Fannie Mae to increase its portfolio by 2% per year, matching Freddie Mac's limit. There was disappointment among market participants that 2% wasn't enough.
The rate cut benefited rolls and improved the carry outlook. JPMorgan Securities analysts noted that TBA rolls jumped a tick after the Fed news. They recommended that investors roll early, noting that dealer balance-sheet pressures are expected to persist through the end of the quarter and possibly to year's end.
The prospect of increased refinancing, in light of the Fed's move, would add to supply concerns. Credit Suisse analysts noted that only 11% (or $315 billion) of the mortgage universe is currently in the refinance window. A 25-basis-point rally would increase exposure to 18% ($543 billion). Analysts point out that this is much less than the refinancing events of September 2003 and April 2002. However, a 50-basis-point rally would expose a comparable dollar amount ($944 billion) to the previous refinance events referred to above.
As a result of the positive response to the Fed's rate cut, the MBS Index rallied 30 basis points on Tuesday alone. According to Lehman Brothers, the MBS Index is up 57 basis points for the month through Sept. 18. This compares with 16 basis points over on the CMBS Index, 13 basis points on the ABS Index, and minus 43 basis points on the Corporate Index.
Discouraging Housing Numbers
Last week, more negative news on the housing market came in the form of the National Association of Home Builders' HMI Index, foreclosures and housing starts, and the problems are not expected to get resolved anytime soon, in spite of Wednesday's Fed action.
The NAHB reported its Housing Market Index fell two points - its seventh straight monthly decline - to 22, tying the record low of January 1991. In addition, the index on expected sales fell five points to 26, the worst on record. The organization expects to see some improvement in home sales beginning in the second quarter of 2008 and improvement by the third quarter for housing starts.
RealtyTrac also reported higher foreclosures. Reports said that the number of foreclosure filings in August jumped 36% from July and were more than double August a year ago. The total number of filings were said to be the highest reported in a single month since the firm started tracking this information two years ago. In particular, California, Florida and Nevada had the highest foreclosure rates in the country last month, RealtyTrac said.
Housing Starts in August fell to 1.331 million, their lowest in 12 years. This was just below consensus expectations of 1.339 million. Building permits fell nearly 6% to 1.307 million units, which was more than expected.
The last week of September sees a pretty full economic calendar. Tuesday brings the Standard & Poor's Case-Shiller Index, Consumer Confidence and Existing Home Sales; Wednesday is Durable Goods; Thursday is the final second-quarter GDP reading, Initial Claims, New Home Sales, Revised Building Permits, and the Kansas City Fed Survey; and finishing up on Friday are Personal Income and Outlays, the final Michigan Sentiment, Chicago PMI and Construc-tion Spending.
The Treasury announces two- and five-year note auctions on Monday, with the auctions scheduled for Wednesday and Thursday, respectively. Fed appearances pick up with a daily dose of speeches. The calendar includes Dallas Fed President Richard Fisher on Monday, Philadelphia Fed President Charles Plosser on Tuesday, St. Louis Fed President William Poole Wednesday, Chicago Fed President Charles Evans and Fed Governor Frederic Mishkin on Thursday, and Atlanta Fed President Dennis Lockhart, San Francisco Fed President Janet Yellen, Governor Mishkin, and St. Louis' Poole on Friday.
Next week is month end, which should provide a supportive tone particularly at the end of the week. The near-term outlook remains mixed, however, despite the Fed rate cut. For example, Barclays Capital analysts moved to an overweight on the mortgage basis last week in response to the 50-basis-point cut in the fed funds rate. Reasons for the move included the possibility of further easing, improvement in rolls and the fact that the improvement in the average dollar price of the MBS universe moving closer to par eliminates some of the negatives associated with slowing speeds. The Barclays analysts do advise investors to monitor the basis closely in case it needs to be taken off quickly.
JPMorgan Securities analysts said that midweek remained negative on the TBA/swap basis. They noted current coupon OAS is negative and carry is still not particularly attractive, even with the stronger rolls.
Application Activity Rises
As expected, mortgage application activity moved higher in response to the sharp drop in mortgage rates. This is the third straight week that activity has increased. The Mortgage Bankers Association reported that the Refinance Index rose 4.6%, to 1962, for the week ending Sept. 14. This is the highest that refinancing activity has been since mid-May. A year ago, the Refinance Index stood at 1749, with 30-year fixed mortgage rates in the low 6.40s. The Purchase Index rose less than 1%, to 452 from 448. As a percent of total applications, refinancings were 43.5% compared with 42.1% previously. ARM share fell to 12.6% from 13.2%.
Initial information for September prepayments shows speeds slowing around 15% to 20%. The decline comes primarily on a drop in the number of collection days in August to 19 from 23. At the same time, mortgage rates were decreased to a 6.57% average in August versus 6.70% in July, which stimulated refinancings based on results of the Refinance Index. Speeds recover in October, as day count increases, and are expected to hold steady in November.
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