The mantra in mortgages lately has been "directional with rates." And indeed, the market has tended to lag on rallies and lead on sell-offs. So this is how it was last week with relatively quiet trading early on as the 10-year hovered and broke through 4%. Strong buying emerged on Wednesday from hedge funds and insurance companies as Treasurys sold off on declining oil prices, which also led to a rally in equities. This continued into Thursday morning with additional support from servicers and foreign banks, but was reversing midday when Treasurys rallied on a stall in oil prices. This move weakened equities as well as buying in Treasurys on corporate hedge unwinds.

Overall, spreads held in a fairly narrow range over the week ending Oct. 27. Meanwhile, 30-year FNMA 4.5s through 5.5s were flat to one basis point wider; 6s and 6.5s were one and four basis points tighter, respectively. Also, 15s were one to two basis points tighter as investors preferred that sector as the 10-year broke through 4%.

Helping to keep spread movement limited is the very favorable supply situation. Originator selling is averaged just $1 billion and has been readily absorbed. Supply currently is focused in 30-year 5s and 5.5s.

Most analysts are neutral on the sector. Near-term concerns include the presidential election, followed by Friday's nonfarm payrolls report and next week's Fed meeting. Other longer-term concerns voiced are risks of reduced bank support due to EITF 03-1, and Fannie Mae's absence as a backstop bid given its accounting probe and need to raise capital. On the positive side are less supply, slowing prepayments and low vol.

Preparing for a flatter curve

Expectations are for the yield curve to flatten in the months ahead. For example, the recently released forecast from the Mortgage Bankers Association has the one- to 10-year Treasury spread averaging 220 basis points in the third quarter and steadily declining to 170 basis points by the end of next year. The MBA predicts short rates will increase 110 basis points over this time versus 60 basis points for the

10-year.

The Bond Market Association also recently released its short-term expectations. The association anticipates the two- to 10-year Treasury spread flattening to 140 basis points by the end of the first quarter 2005 from 151 basis points at the end of the third quarter 2004. The BMA forecasts the two-year and 10-year Treasury notes to increase 59 and 48 basis points, respectively.

With this kind of curve flattening, Bear Stearns notes that the increase in short-term rates changes the discounting rate on the cash flows. In addition, refinancing risk is reduced. With this combination, Bear believes premium coupons are likely to perform the best.

Bear Stearns analysts note that returns from mortgages come from coupon, amortization/accretion, reinvestment, and price changes, the first three can be considered returns from cash flow while the last one is mostly attributable to the duration, which can be hedged.

The cash flow effect from rising short-term rates should be positive for premium coupons and neutral on discounts, Bear analysts added. For example, increasing interest rates typically cause prepayments to slow allowing for less amortization of the premium and, in turn, benefiting returns. While currently there is an attractive opportunity for refinancing into ARM product from fixed, Bear expects curve flattening with faster increasing short rates will reduce this opportunity.

Regarding the duration effect, Bear states that premiums have much less exposure to the five-year and longer part of the curve. To equate returns of all coupons, analysts say a portfolio could hedge the duration risk of the longer part of passthroughs, such as paying fixed on 10-year swaps, leaving passthroughs with only their short duration. With this hedge, Bear demonstrates premiums should outperform discounts in a flattening yield curve environment. For instance, analysts calculate that with an 80 basis point flattening, 30-year Fannie Mae 6% TBAs (FNCL 6s) have a projected return of 3.46% over the next year; 5.5s follow at 3.32%. Analysts also noted that 4.5s and 5s are the worst performing at about 2.66% and 2.13%.

Mortgage application activity mixed

Mortgage application activity was mixed for the week ending Oct. 22. The MBA said that the seasonally adjusted Purchase Index fell 4% to 441, while the Refinance Index was up nearly 4% to 2234 in response to the decline in mortgage rates. Unadjusted, the Purchase and Refinance Indexes were up 6% and 15%, respectively. As a percentage of total application activity, refinancings were 47.7% versus 45.6% in the previous report. ARM share activity was essentially flat at 34.9% from 34.8%.

Mortgage rates declined again last week as a result of the latest rally that pushed the 10-year through the 4% level. Freddie Mac reported that the 30-year fixed rate mortgage rate was 5.64%, down from 5.69% last week - the lowest the rate has been since April 1, when it was 5.52%. The 15-year fixed rate mortgage rate slipped six basis points to 5.01%, and the one-year ARM reported in at 3.96% versus 4.01% previously. Given the lower mortgage rate levels, it is expected the Refinancing Index will hold in the 2200 area in this week's MBA survey.

So far in October, the Refinance Index has averaged 2113 and the 30-year mortgage rate around 5.75%. This is little changed from September's averages of 2091 and 5.75%. In August, mortgage rates averaged 5.87% and the Refinance Index averaged 1813. These numbers support expectations that prepayment rates will show modest increases in October, and then hold essentially flat in November. The October prepayment report will be released Thursday.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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