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."

Deutsche also estimates that $44 billion in 10-year equivalents would need to be purchased in a 25 basis point rally to re-hedge shortening of mortgage portfolios. On the report date (May 24), 10-year yields were at 5.14%, and at press time, were down to 5.08%, still looking to rally further.

Somewhat offsetting are near term supportive events. Last Friday was month's end and the MBS Index extended 0.12 years according to Lehman Brothers, and looming are non-farm payrolls and settlement on 30-year conventionals. According to Greenwich Capital, mortgages tend to do well during these events.

Prepayment Outlook

This Friday, June 7, the housing agencies release their respective prepayment reports for the month of May and there have been some increases in expected speeds. Speeds in unseasoned 6s and 6.5s are predicted to increase about 10% to 20% while seasoned vintages are expected to be unchanged to 10% slower. The outlook on 7s is a bit mixed. Lehman is calling for declines of about 10% for unseasoned and seasoned vintages while UBS Warburg forecasts increases of 5% to15% in unseasoned and moderated seasoned originations. Higher coupons are expected to be little changed from April's levels. Looking to June, increases of 10% to 20% are now predicted for 6s through 7s in most vintages while higher coupons look to be unchanged to about 5% faster. Additional gains of 15% to 20% are anticipated for 6.5s and 7s in June bringing speeds back to levels seen in March.

Mortgage Indexes

For the week ending May 24, the Mortgage Bankers Association reported that mortgage applications increased slightly. The Refi Index gained 5% to 1498 while the Purchase Index was up 1% to 348. Salomon Smith Barney noted the increase was smaller than expected and suggest that as the Memorial Day holiday approached, activity was limited. Looking ahead to next week, numbers will be distorted by the shortened holiday week; however, with rates holding lower, they expect the level of refi activity to remain around current levels.

Freddie Mac reported a drop in fixed mortgage rates to their lowest levels of the year for the week ending May 31. Thirty-year fixed mortgage rates average 6.76%, down five basis points from last week and is again at its lowest level since November 21's 6.75% rate. The 30-year rate hit a record low of 6.45% on November 8.

The 15-year mortgage rate dropped six basis points to 6.22%, also its lowest since 6.24% for the week ending November 21. And last, the 1-year ARM rate fell to 4.76% from 4.85%.

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