Mortgages struggled early last week on the lofty price levels and increased concern of 5.5s breaching $102. The week saw better selling from a variety of accounts including relative value, fast money and overseas accounts. In addition, originators were average to slightly above average sellers on the week. Towards the latter part of the week, the cheapening started drawing investors back, particularly in 5.5s, as prices moved near the middle of their range. Other areas of the coupon stack benefited as well, for various reasons. For example, 4.5s saw strong buying from dealers last Wednesday as they covered shorts. In comments from JPMorgan Securities, analysts believe the Street is significantly short 4.5s and is likely to remain that way for the near term. Meanwhile, 5s and 5.5s were gaining support from CMO dealer related buying; while higher coupons gained from the pricing of a $2.5 billion Gold 6.0 trust.
In general, the mortgage outlook remains favorable, with spreads expected to hold firm due to the low volatility, declining fixed rate supply, and continued overseas demand. Also noted is a sharp drop in dealer positions. A JPMorgan report stated dealer positions in January have dropped sharply and net holdings are at negative levels for the first time in two years. "The Street is clearly trading mortgages from the short side in a period of little supply," which are overwhelming positive technicals, analysts report.
As far as volatility goes, many believe it can go even lower. For example, RBC Dain Rauscher Senior Mortgage Strategist Kevin Jackson pointed out that implied volatility was lower in the first seven to eight months of 1998. At that time, he noted, hedge funds were active vol sellers, which drove down implied volatility. In addition, realized volatility was also low until the Asian financial crisis hit.
He believes volatility could go lower in 2005, and that the range trade can continue unless something unexpected occurs like in 1998. One reason for the lower vol trend, he says, is that the Fed has become more transparent.
So what could cause spreads to really widen this time? One thing, according to Bear Stearns is a rally in the market that raises volatility and refinancing concerns. In addition to any changes in supply, Bear says that if overseas support declines, that would be worrisome as "both the banks and GSEs seem indifferent."
Application activity declines in holiday-shortened week
The Mortgage Bankers Association reported a decline in application activity for the week ending Jan. 21. The Purchase Index slipped 2% to 439 on a seasonally adjusted basis, while the Refinance Index was off 6% to 1933. Expectations were for activity to hold steady to slightly higher, but it tends to be more difficult to gauge activity during holidays. On an unadjusted basis, purchases were down 6.5% and refinancings were off 15%.
As a percentage of total application activity, refinancings were 46.5% versus 48.9%. ARM share also fell to 31.7% from 32.8%.
Both 30- and 15-year fixed mortgage rates declined just one basis point in Freddie Mac's latest survey amidst expectations for larger declines. For the week ending Jan. 28, the 30-year fixed rate mortgage averaged 5.66% and the 15-year fixed rate was 5.14%. Bear Stearns analysts said each basis point that the mortgage rate falls below 5.60% pushes another $30 billion into the refinancing window. Given this report, as well as the latest sell-off, however, it appears this risk has been reduced for the time being.
In other rate information reported, the 5/1 hybrid ARM rate came in at 5.02%, down three basis points; while the one-year ARM rate jumped seven basis points to 4.18%. Looking ahead to this week's MBA report, analysts expect the Refinance Index to rebound to the 2000 to 2100 area.
Prepayment outlook
Prepayment speeds over the next two months are expected to decline. Traditionally, these are the two slowest months of the year. In addition to the seasonal factors, a lower day count should pull speeds lower. In January, prepayments are anticipated to slow around 8% overall, while February is looking at 5% to 7% in slowing. Activity is anticipated to pick up in March, with speeds increasing around 10% from February's levels.
The near-term outlook also sees GNMAs continuing to prepay faster than conventionals, particularly in the lower coupons. In comments from Lehman Brothers, analysts say that strong home price appreciation is the primary reason for the higher GNMA discount speeds. As previously reported, home price appreciation was very strong year-over-year in the third quarter of 2004. As a result, Lehman says it expects the trend of much faster GNMA discounts to continue in the months ahead.
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