Mortgage spreads were little changed over the past week. The sector continued to be supported by balanced flows, even as originator supply increased, and it benefited from month-end extension buying, as well as a near-term favorable outlook.

According to Greenwich Capital Markets, the May Refunding tends to be a strong period for spreads in general and mortgages in particular. Also, they note that volatility tends to decline after the non-farm payrolls report, and further support is expected from conventional settlement notification that begins on Thursday.

Mortgage banker selling picked up from about $500 million per day for the last full week of April, to around $1 billion last week. With mortgage rates below 7%, supply concerns are starting to weigh on the market, especially as demand from the GSEs is lower. The weakening technicals have made analysts more cautious on the sector. Investors too have taken some chips off the table according to JP Morgan's latest MBS Client Survey. As they reported last week, the share of underweights rose 5.4% to 23.0%. The gain came at the expense of overweight positions which declined to 27.9% from 32.4%, and the share of neutrals which fell from 50.0% to 49.2%. The firm noted that rich valuations prompted investors to take profits and move to a more neutral position.

Mortgage indexes

Refinancing applications finally responded to the decline in mortgage rates over April. According to the Mortgage Bankers Association, its Refi Index surged 16% to 1534 for the week ending April 26 and the Purchase Index rose 5% to 368, setting another record high. Refi applications as a percent of total applications were 38.7% versus 36.5% in the previous release. In comments, Salomon Smith Barney noted that despite the increase in the Refi Index, the average for April 2002 was the lowest since 2000. With rates holding lower, refi's are expected to move higher in the next release. Salomon predicts a 10% rise which would bring the index to around the 1700 level.

According to Freddie Mac's latest mortgage rate survey, 30-year fixed mortgage rates fell 10 basis points to 6.78%, slightly more than was expected. At current levels, rates are at their lowest level since 6.75% for the week ending November 21, 2001. Further, 30-year mortgage rates are down 40 basis points since their high this year of 7.18% reached on March 28.

At the same time, 15-year mortgage rates declined nine basis points to 6.26%, also its lowest since November 21. On the steeper curve related to expectations the Fed will keep rates unchanged through the summer, the one-year ARM rate plunged 16 basis points to 4.75%. This is the lowest since 1994.

As a result of the decline in mortgage rates, prepayment concerns are likely to heighten. According to a recent report from Bear Stearns, at current market levels, they do not see another huge refi wave taking shape; however, if mortgage rates reach 6.60%, 2001 vintage 6.5s will be exposed to a refi risk. This coupon represents 52% of new (2001 vintage) 30-year production.

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