Last week's flows were fairly balanced as the market continued to respond favorably to the benefits of a Fed on hold. Profit-taking was observed by money managers, particularly in 15-year MBS, and arb accounts, but were balanced out by buying in lower-coupon 30-years.

Banks, insurance companies, and CMO dealers were also noted buyers, with interest in the discount sector as prices rose and prepayment risk increased. Originator selling was nearly non-existent with supply limited to about $500 million per day. This, however, is expected to increase in the weeks ahead. All in all, spreads moved several basis points tighter over the Wednesday-to-Wednesday period in both 15s and 30s.

Street analysts remain neutral to modestly overweight on the MBS sector versus Treasuries. In comments last Thursday, JPMorgan said that it was neutral with a slight negative bias as it was concerned that swap spreads had come in too fast due to the heavy corporate issuance and increased budget deficits. Keeping them from being negative, the basis is the expected decline in volatility as a result of the Fed being on hold. Other firms add the favorable carry, declining supply, and ongoing demand as support for being overweight the sector.

Looking ahead to this week, which is month-end, Lehman Brothers expects the MBS sector to extend 0.11 years in April, which suggests good buying from indexers. This compares to a 0.05 rise expected in the Aggregate, 0.06 years in the credit index, 0.07 years in Agencies, and a contraction of 0.06 years in the Treasury Index. In addition, there is the May Treasury Refunding looming which "tends to be a very strong period for spreads in general and mortgages in particular," according to Greenwich Capital Markets.

Mortgage indexes

Since the beginning of April, the yield on the 10-year Treasury has dropped some 35 basis points. At the same time, the Mortgage Banker Association's Refi Index has shown little response, even as mortgage rates have dropped once again below 7%. While refi applications are lower, Countrywide Securities says we are not out of the woods regarding a refi rebound (see story p. 11).

They note that mortgage bankers are running at a still strong 100% of capacity (versus 140-150% in November and December). Countrywide says that if market rates remain range- bound, the drop in refi applications should lead to diminished strains on capacity, which could then allow mortgage rates to decline further. For now though, the impact of lower refis means modest prepayment declines in April, with stronger slowing seen in May.

For the week ending April 19, the Mortgage Bankers Association announced a modest increase in mortgage applications in response to the lower rates over the past month. Specifically, the Refi Index rose 6% to 1321 with conventional refis up 6% to 1431 and government refis higher by 9% to 744. The Purchase Index gained 4% to 352. This is its second highest level this year.

Responding to the report, Salomon Smith Barney noted the subdued reaction of the Refi Index over the last month despite the lower rates. Based on its recent performance, the average for April is on track to be the lowest since 2000. This suggests to them that the large cuspy issues will finally slow from their relatively high prepayment levels. Based on the latest drop in rates, they expect to see further increases in the index of perhaps 10% next week.

Freddie Mac just reported that mortgage rates dropped again. The 30-year fixed mortgage rate fell six basis points to 6.88%. This is down 30 basis points from its recent high of 7.18% for the week ending March 28. It currently is at levels averaged in February and early March. The 15-year fixed mortgage rate declined seven basis points to 6.35%, and one-year ARM rates came in at 4.91% versus 4.95% last week.

Prepayment outlook

At this time, April prepayments are predicted to drop 10-20% for most coupons and vintages. In May, Lehman and CS First Boston expect Fannie Mae MBS to decline another 20-30% in the cusp coupons and hold within a narrow plus/minus range for 7.5s and higher. UBS Warburg expects May to show modest slowing of 5% or less. In June, speeds are predicted to reverse and move higher.

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