Federal Reserve Chairman Ben Bernanke said at the annual Jackson Hole Economic Policy Symposium on Aug. 31 that the labor market's stagnation is a grave concern for the Fed. A week later, August nonfarm payrolls printed at just 96k, which Wells Fargo described as "fairly low" quality.
So how could odds not be high that the Fed would announce QE3 with MBS purchases in the mix? Credit Suisse's metric calculated the mortgage market was pricing in around an 85% probability ahead of the Federal Open Market Committee's (FOMC) monetary policy decision, while BNP Paribas' measure had it in the high 90s.
Cutting to the chase, on Thursday the FOMC did what markets were anticipating as far as implementing QE3 and extending the time frame for low rates to mid-2015 from late 2014. However, the committee surprised the market in that the buying was limited to agency fixed-rate MBS only and not Treasurys, although it will continue Operation Twist through yearend as scheduled. QE3 is open ended at $40 billion a month with buying beginning Sept. 14 with $23 billion expected through the end of September.
While the FOMC's statement said economic activity continued "to expand at a moderate pace in recent months", employment growth was observed as "slow" with the unemployment rate remaining "elevated." What motivated the Committee to turn more aggressive in its actions was concern that without more accommodation, "economic growth might not be strong enough to generate sustained improvement in labor market conditions."
In the post-FOMC press conference, Chairman Bernanke indicated the bond purchases would continue until there was "sustained improvement" in the economy to generate jobs and added "the last six month's isn't it." He also said that the economy needed to be strong enough to support improving labor market conditions.
In an FAQ, the New York Federal Reserve Bank (NYFRB) said that while buying would be concentrated in TBAs (To-Be-Announced), it could purchase other agency MBS which would indicate other coupons and specified pools. It also said the Open Market Trading Desk could use dollar rolls and coupon swaps in order to facilitate settlement.
Together with the ongoing reinvestment of its MBS and debenture paydowns ($37 billion from mid-September through mid-October), NYFRB buying over the near term is anticipated at a daily average pace of $4.0 billion. Meanwhile, mortgage banker supply is averaging around $2.0 billion per day, including this week.
Given technicals like that, 30-year FNMA 3.0s and 3.5s responded accordingly by surging 34+ ticks and 26 ticks, respectively, on Thursday with spreads to 10-year notes tightening by 1 point and 3/4 of a point. Barclays MBS Index outperformed Treasuries by 26 basis points, while the current coupon spread to 10-year notes tightened 15 basis points. There was widespread participation, not surprisingly, including from servicers.
Mortgages continued to outperform on Friday with FNMA 3.0s and 3.5s hitting new record highs by mid-morning. At their intraday highs, FNMA 3.0s and 3.5s were up 13 and 9 ticks compared to -3/8 of a point on 10-year notes. Profit taking emerged from fast and real money that pushed prices back to near unchanged on the day before buyers returned and pushed spreads to their tights of the day at 1/4 to 3/8 of a point.
Ahead of the FOMC's decision, the focus of earlier week trading was influenced by QE3 expectations. While Monday provided a brief distraction via the August prepayment reports, investors were not deterred from faster than expected speeds in lower coupons because of the QE3 prospects.
Roll trading was the focus on Tuesday as it was Class A (30-year FNMA and FHLMC) 48-hour day; however, the Sep/Oct 3.5 roll increased to an intraday high of 10.5/32s from 7/32s (Tradeweb) due to the Fed buying expectations. And even after the calendar flip to October/November on Wednesday, the rolls recorded notable strengthening.
Investor participation was widespread on Wednesday with buying observed from banks, money managers, hedge funds, REITs, structured desks and fast money, as well as, the Fed. In addition, they were aided by lower prices as Treasurys sold off on a combination of risk on sentiment on continued positive developments from Europe (a favorable German court ruling on the European Stability Mechanism), and $66 billion in three- and 10-year notes and 30-year bonds that were being auctioned.
Specified trading had a quiet start to the week with the focus on dollar rolls and class A 48-hour day; however, BWICs picked up on Friday on continued demand for call protected paper, particularly in light of the FOMC action. Payups on lower coupons, however, are expected to experience limited increases as a result of strengthening in dollar rolls on FNMA 3.0% and 3.5%.
Tradeweb reported volume averaged 116% for the week through Thursday compared to 105% previously. Excess return to Treasuries on Barclays MBS Index totaled 31 basis points from Sept. 7 with the month-to-date return at 46. The 30-year current coupon yield fell 11 basis points to 2.36% with the spread to 10-year notes tightening 19 basis points to 61.
FHFA Keeps Tweaking
There was some news of particular interest to MBS and that was an announcement from the FHFA, FNMA and FHLMC of a new representation and warranty framework for conventional loans sold or delivered on or after January 1, 2013. Included in the new framework is certain rep and warrant relief for loans with 36-months of consecutive, on-time payments, and for lenders participating in streamlined refinance programs, including HARP, relief would be eligible after an acceptable payment history of just 12 months following the acquisition date. The GSEs would also evaluate the quality of loan within 30 to 120 days of acquisition rather than after it becomes delinquent.
Credit Suisse analysts said the changes should gradually loosen up the extremely tight credit conditions which suggest refi and purchase activity could pickup in 2013. Cross servicer HARP activity is also seen as gaining from the changes.
The FHFA is anticipated to release a proposal at any time on state level g-fees. In recent research, from JPMorgan Securities analysts pointed out that while g-fees reflected in part credit attributes like FICO and LTV, they don't address loss severity given default and one key driver of this is the foreclosure timeline. For instance, certain states typed as judicial take longer than non-judicial states to liquidate and that increases severity as the servicing advances eat into principal recovery.