Through Tuesday, mortgages had made tremendous gains on better buying, below normal supply, tighter swap spreads and lower volatility from the middle of the previous week.
For example, month-to-date through April 17, Lehman Brothers' MBS Index was underperforming Treasurys by one basis point. Mortgages staged a dramatic recovery through last Tuesday's posting to 72 basis points.
Year-to-date, the MBS Index is underperforming Treasurys by just two basis points compared to negative 234 basis points for U.S. corporates, negative 508 basis points for CMBS, and negative 517 basis points for ABS.
However, overall MBS volume was below normal in the first half of the week. Overseas investors, in particular, were a strong buyer, though money managers, real money and fast money also were active participants. In fact, buyers outnumbered sellers about 5-6 to 1 in the first two days of trading. Interest was focused primarily in 5%s through 6%s.
Meanwhile, supply was running at less than $1 billion per day and consisted of 5s through 6s. On Wednesday, mortgages were lagging on limited volume as investors were taking profits following the recent strong gains.
In other mortgage sectors, through the first half of the week, GNMA/FNMA was slightly underperforming on a combination of fading credit concerns and higher supply. Gold/FNMA posted gains, 15s underperformed 30s as the yield curve flattened, while the specified pool sector was quiet despite pay-ups to TBA being substantially below theoretically pay-ups.
Mortgage Outlook
Investors remain very sensitive to the ongoing credit and housing risks. Also weighing on the longer-term MBS outlook is supply.
Last week analysts were neutral on the mortgage basis primarily for this reason. Lehman Brothers analysts, for example, estimated supply will run at $40 billion to $50 billion per month for the rest of the year. While demand has picked up from commercial banks and overseas investors, analysts do not believe it will be sustained. Banks expect capitalization concerns to continue, particularly if the housing market continues to weaken. Further, Lehman projected that banks and thrifts have recognized only about $70 billion of the roughly $320 billion in projected losses.
Over the near term, analysts anticipate overseas demand to remain strong, but longer-term they believe asset allocation trends are still in play. This includes greater diversification from official institutions from bonds into equities, and from the dollar into other currencies.
"In the best case, we think overseas demand can total $150 billion to $200 billion per year, which falls far short of the $600 billion of demand needed to absorb supply," Lehman analysts said.
As expected, mortgage applications dropped nearly 14% for the week ending April 18 as mortgage rates rose sharply. The Mortgage Bankers Association reported that the 30-year fixed contract rate jumped 30 basis points to 6.04%. Mortgage rates were last above 6% in mid-March. Meanwhile, the one-year ARM rate fell to 6.93% from 7.02%.
The jump in rates led to a 20.2% drop in the Refinance Index to 2286.3 and puts this index at its lowest level for this year. The Purchase Index declined 6.4% to 357.3. The Conventional Purchase Index fell 7.5% while the Government Purchase Index was off just 2.7%.
As a percent of total applications, refinancings dropped to 49.2% from 53.5% in the previous report. ARM share rose to 6.6% from 6% previously.
Prepayment Outlook
Prepayment speeds on FNMAs are currently projected to be about 2% higher overall in April, primarily due to increases in the 5% coupon.
Higher coupons, in aggregate, appear to be flat to lower. GNMA speeds are forecast higher up 6% overall. The 5% coupons are also a major contributor to the increase up 11% overall. However, unlike FNMAs, 5.5% and 6% coupons look to be up 4% to 5%.
In general, a two-day higher day count appears to be mostly offset by higher mortgage rates and lower refinancing activity.
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