As last week opened, the market was feeling pretty good as the weaker-than-expected jobs report increased the odds that the Federal Reserve would pause in June. On top of that, the week saw limited key data to roil the markets, and support potential from reinvestment of paydowns and roll related trading. But the market got its hopes quickly deflated following comments from Fed Chairman Ben Bernanke Monday afternoon at an international monetary conference. His hawkish tone moved the odds for another rate hike in June.
Over the week, flows were mostly two-way with broad domestic participation. The early week saw moves up-in-coupon - despite the curve flattening - as investors took advantage of recent cheapening in the higher coupons on the previous week's strong down in coupon trade. Midweek, there was some reversal of the move up, with decent buying again in lower coupons. Activity slowed into Thursday's trading session as global equity distress returned to the forefront. In general, investors are more or less trading the market right now - adding on weakness and selling on strength - given the risks. Meanwhile, originator selling held to average levels last week. Supply is currently split between 5.5s, 6s and 6.5s.
The longer-term outlook for mortgages is looking favorable at this time. For example, JPMorgan Securities analysts last week upgraded their recommendation to modest overweight from neutral. One reason they cite is that spreads are near their widest levels since the start of the year. Another factor is that longer dated vol has the potential to soften for three reasons: more clarity from the Fed in coming weeks, the potential cap on the GSEs' portfolios, sizeable supply recently in longer-dated vol; and longer dated vol is substantially higher in the U.S. versus Europe and Japan, which suggests that volatility has the potential to move lower. UBS and Bear Stearns are also favorable on the sector for similar reasons. UBS believes that after the Fed Chairman "establishes his inflation-fighting credentials with perhaps another hike," implied volatility is likely to drop. Bear Stearns analysts add that bank demand is holding steady with limited loan demand keeping the focus on mortgages, while overseas interest should pick up following a Fed pause.
However, near-term issues continue to be vol risk associated with both the data dependency of the Fed and global equity risks, ongoing lack of support from Asia, and high dealer inventories.
This week, volatility is anticipated to pick up with lots of economic data. In particular, the market gets key inflation data on Tuesday and Wednesday, which will provide additional clues to potential action in late June by the Fed. Also, the Beige Book is released on Wednesday with additional information regarding various aspects of the economy around the country.
Application activity slips
Mortgage application activity was down just slightly for the week ending June 2, according to the Mortgage Bankers Association. On a seasonally adjusted basis, the Purchase Index was unchanged at 395.6 versus 395.5 in the previous report. Meanwhile, the Refinance Index fell 3.8% to 1356. A year ago, both indexes stood at 479 and 2362, respectively, with 30-year mortgage rates at 5.62%.
As a percentage of total application activity by dollar volume, refinancings slipped to 36.3% from 37.10% in the previous report. ARM share recorded a large decline to 42.8% from 45.2%.
Mortgage rates decline with recent rally
Mortgage rates declined last week as expected according to Freddie Mac's latest survey. The 30-year fixed mortgage rate averaged 6.62% - where it was two weeks ago - and down five basis points from the previous week. In the 15-year sector, rates slipped three basis points to 6.23%; 5/1 hybrid ARMs declined six basis points to 6.20%; and one-year ARMs fell five basis points to 5.63%.
Application activity is expected to generally move lower in the weeks ahead in response to the increase in mortgage rates. Analysts also anticipate that the relationship between mortgage rates and the Refinance Index will start behaving as expected because the attractiveness of ARM alternatives is becoming less as mortgage rates continue to rise.
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