The mortgage market continued to experience active two-way flows by all account types. The week started off with better buying as the month was winding down, but following the successful two-year note auction on Wednesday, which rallied the market, profit-taking picked up, as well as interest in the down-in-coupon. Originator selling was modest at between $500 million and $1 billion per day. The fairly-balanced flows kept mortgage spreads one basis point tighter in 30-year Fannie Maes and 15-year 5.5% and 6% coupons over the Wednesday-to-Wednesday period, while higher coupon 15-years were firmer by two to three basis points.

Two weeks ago, the mortgage market was in the comfortable position of no extension and no contraction risks. But that situation is beginning to change with the rally in Treasuries since mid-May. Over the past two weeks, the 10-year Treasury and swap yields have fallen over 20 basis points to 5.08% and 5.51%, respectively. This has led to some convexity buying in 10-year Treasury which has contributed to their decline - further declines are predicted to lead to spread widening in mortgages. In last week's research from Deutsche Bank Securities, they believe a rally to 5.45% on 10-year swap rates would trigger significant convexity receiving in the swap market. And, with mortgage prices so high, they do not expect MBS hedgers to purchase more MBS to hedge their durations. As a result, "receiving in swaps in a rally is likely to tighten swap spreads at the expense of MBS and Treasuries alike."

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