The mortgage-backed securities market was hit by a triple whammy this week, market sources say, as it absorbed the effects of the Federal Reserve's quarter percentage point interest rate increase, the effects of end-of-quarter bookkeeping and a pre-July 4th malaise.
"The sales force is kind of watching the paint dry," said one MBS trader mid-week. "The occasional trade gets done, but there is not a lot of retail volume."
Still, late in the week, MBS rallied following the Fed's stance of neutrality for tightening monetary policy. However, this occurred only after mortgage bonds fell less than U.S. Treasurys, since prepayment speeds were mixed amid rising interest rates.
"Prepayment speeds of 30-year Gold premium coupons declined by 6% to 11%," said Warren Xia, a senior prepayment analyst at Banc of America Securities. "Going forward, we expect premium speeds to continue to decline in the months ahead, starting with even sharper declines in July."
Freddie Mac, the second biggest buyer of U.S. home loans, said prepayments from mid-May to mid-June slowed an average of 6% for pass throughs in 7% coupons through 8.5% coupons. Prepayments accelerated in all others except 5% coupons.
Fannie Mae, the biggest buyer of mortgage securities, is set to release its data on July 8.
"Mortgages are still outperforming the Treasury market in this downtrade," said Art Frank, senior mortgage analyst at Nomura Securities. "But it is a thin pass-through market, so dealers do not want to take a lot of risk. So it doesn't take as much volume as normal to move mortgage spreads around."
The constant prepayment rate, or CPR, on 30-year 6% coupons rose to 4.7 CPR from 4.0 CPR. According to Xia, prepayment speeds in the months ahead will be 4% CPR to 5% CPR higher than 1997 if rates remain stable at their current levels.
Despite the slight rally caused by the Federal Open Market Committee's neutral stance, U.S. bonds fell for the first time in five days as a stronger-than-expected manufacturing report convinced some investors the Fed is not finished raising interest rates.
The National Association of Purchasing Management's factory index sparked Treasury declines after it showed manufacturing activity rose to its highest level since July 1997. The group's index of prices paid by manufacturers climbed to the highest since October 1997.
"Dealers have had to widen spreads out to move product," said one MBS player. "June has just been a rough month for mortgages all around. But my suspicion is that after the Fed clarifies what they're doing, we might see some decent buying in mortgages, which have gotten extremely cheap recently."
The ongoing liquidity concern in the market was still present last week, sources said. The level of buyside activity has slowed, widening from 133 basis points off the 10-year bond to 140 basis points over late in the week.
"This was a painful widening, and it resulted in some losses," said another MBS trader.
However, by last week's end, spreads on structured products tightened as investors moved into the market.
"Mortgages have gotten a bit tighter on fairly light volume," said the source. "But this quarter point interest rate increase was simply a preemptive measure. Still, despite the neutral stance, the Fed seems to have left the door open for more tightening." - AT
