Attention last week was on the Federal Open Market Committee and less on the subprime market woes. Early week market flows were relatively light and two-way as investors waited for the release of the FOMC's statement on Wednesday afternoon.
There was not too much data either to divert attention away from this statement, and the data that did come out gave out mixed signals. For example, last Monday the National Association of Home Builders reported a weaker-than- expected decline in the Housing Market Index to 36 in March from 39 previously. The index is above its 15.5-year low of 30 recorded last September - which has been given as the reason for the market's lack of response. Lehman Brothers economists said that this reported weakness for the season's first month would not be welcome news at the Federal Reserve.
On the other hand, housing starts jumped 9% to 1.525 million, tripling consensus expectations. However, the data was mixed with housing starts in the Northeast and Midwest down, while the South and West were higher. The effects of inclement weather were a factor in the mixed report. Economists said that builders have been responding to the slowdown in housing by cutting starts, which suggests a limited impact on overall economic growth.
Volume picked up on Wednesday in anticipation of the FOMC news. There was better buying from a wide range of investors, including banks, servicers, money managers, and fast money. The buying was prompted by expectations of a volatility drop after the statement. While mortgages lagged on the sharp rally following the news and a slight uptick in volatility, buying continued as the curve steepened, though fast money started taking profits into the strength. Over the week, investor focus was primarily in the belly of the stack: 5.5%s and 6%s. Meanwhile, 15-year MBS also benefited from steepening in the yield curve.
The FOMC news rallied the market and steepened the curve as many interpreted some rewording in the language of the statement that the Federal Reserve had dropped its tightening bias. In the statement released last week, the committee dropped the phrase, "the extent and timing of any additional firming" and replaced it with "future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth."
The 10-year Treasury hit an intraday high of up 8+/32nds on Wednesday, before closing up 7+ ticks with the yield at 4.518%. On Thursday, unwinding of flattening trades had the longer part of the curve substantially lower with 10-years down over 15/32s and the yield up to 4.581%. With the unwinds, the 2s/10s curve was actually upward sloping with a 1.1 basis point spread difference in yields at midday on Thursday.
Overseas investor participation remained on the light side with trading activity mostly up-in-coupon. There is talk that activity could pick up with bogeys shifted more toward current market levels. The steepening of the curve, which stimulates the carry trade, should also add to their interest. This week has potential for some fiscal year-end activity as well from some Asian countries.
After weeks of above-average selling from originators of $1.5 billion to $2.0 billion per day, the average held to $1 billion per day through Wednesday. On Thursday, mortgage banker selling doubled. Supply for the week was primarily in 6s and 5.5s.
Between the better buying, limited supply, and lower volatility, mortgages' performance was slowly moving back into positive territory last week. Month-to-date through Wednesday, March 21, Lehman's MBS Index was up 13 basis points, bringing year-to-date to +2 basis points. Year-to-date, MBS have a slight lead to ABS (-2 basis points) and CMBS (-2 basis points) and corporates (+1 basis points).
Mortgage outlook
The economic calendar picks up this week after a light one last week. On tap for Monday is new home sales, followed by consumer confidence on Tuesday and durable goods on Wednesday. Thursday's data include the final reading for the fourth quarter GDP, and the Friday data include personal income and outlays, Michigan sentiment, Chicago PMI and construction spending. The Treasury is also scheduled to auction off two- and five-year notes on Wednesday and Thursday, respectively.
Finally, Fed Chairman Ben Bernanke is scheduled to speak on Wednesday before the Joint Economic Committee (JEC) regarding the economic outlook. The markets will be listening closely for clarification on the Federal Reserve's statement given the uncertainty of whether the Fed's bias has shifted from tightening to easing. The JEC also noted that Chairman Bernanke would be questioned about the subprime risks and large trade deficits in relation to the economic outlook.
This week is also month-end. Beginning April 1, hybrids will be included in Lehman's MBS Index. As a result, the forecast duration change for MBS is -0.14 years. In the other major sectors, Lehman analysts predicted extensions on both the Treasury and Agency Indexes at 0.03-years and the Corporate Index at 0.13-years. The Aggregate Index is expected to contract 0.05-years on the MBS influence.
Analysts' tone last week remained in the neutral to positive range. Those in the neutral camp remained concerned with subprime risks, in addition to the increased negatively convex mortgage universe and higher prepayment risks. Firms that recommend overweights cite low contagion risk from subprime, expectations for volatility to tick lower, and some market stabilization following the recent subprime and global market scares.
Application activity declines slightly
Mortgage application activity slipped 2.7% for the week ending March 16. According to the Mortgage Bankers Association, the Refinance Index fell 4.5% to 2208.6 from 2312 - its highest level in 18 months. Activity, however, is up 37% from a year ago when the Refinance Index was 1614 and 30-year mortgage rates averaged 6.24%. The Purchase Index slipped less than one percent to 410.6 from 414.3. Purchase activity is up slightly from 399 a year ago.
As a percent of total applications, the refinance share was 45.3%, down from 46.2% in the previous report. ARM share was also lower at 20.9% compared to 21.9% previously.
Mortgage rates held in a narrow range last week as the market was in a holding pattern ahead of FOMC. According to Freddie Mac, both 30- and 15-year fixed mortgage rates rose just two basis points to 6.16% and 5.90%, respectively. A year ago, levels were at 6.37% and 6.00%.
The adjustable side was mixed with five-year hybrid ARMs increasing to 5.91% from 5.90%, while one-year ARM rates slipped two basis points to 5.40%. Application activity is expected to hold in a narrow range last week as mortgage rates remain stable.
Prepayment outlook
Prepayment speeds are seen jumping 25% in March. The period includes three additional collection days compared with February (22 versus 19) and seasonals start to factor in as well. This rise in prepayments is partly caused by the higher refinancing activity due to the recent rally in rates.
April prepayment speeds are expected to hold flat as a result of a two-day decline in the day count. Finally, May is projected to be up about 15% based on a higher day count and strengthening seasonals.
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