The New Year rally in mortgages petered out last week as the sector came under strong selling pressure. After gaining 25 basis points in excess return, according to Lehman Brothers' MBS Index in the first four days of trading, last week saw 12 basis points of erosion in the first half of the week. Month to date through Jan. 10, the MBS Index is up 13 basis points.
Factors encouraging the selling include the backup in yields on stronger-than-expected economic data, limited Asian support so far this year, and a widening in swap spreads due, in part, to deal-related hedge unwinds. Treasury yields have steadily backed up since the sharp gains in December's employment figures reported Jan. 5. Prior to the release, the 10-year Treasury yield had rallied to 4.618% from 4.708% as of the close of 2006. The yield was back above 4.70% following the large drop in initial claims on Thursday. Initial claims declined by 29,000 to 299,000 in the week ending Jan. 6. IFR Global Markets' economists note that while the data continues to show volatility, a number below the 300,000 mark might point to a tight labor market. Of course, this added to inflation concerns. In addition, last week's trade data and wholesale trade numbers were expected to lead to upward revisions to economists' estimates for the fourth quarter GDP. The outlook for decent economic growth further reduced the odds that the Federal Reserve will ease in the foreseeable future.
Despite the selloff and more attractive yield levels, Asian investor participation remained very limited last week. This provided encouragement to domestic accounts to take profits. Domestic selling was widespread and came from money managers, banks, servicers and other fast money and was felt up and down the coupon stack. While originator selling kept to its average of $1 billion per day, it weighed on the market with the lack of buyers. Supply was concentrated in 5.5% and 6% coupons. Since prices peaked on Jan. 4, FNMA 5% and 5.5% coupons are down 13 and 10 ticks, respectively; 6s have declined 8/32s; and 6.5s are off 5/32nds. Prices were losing additional ground as of midday on Thursday as the market was selling off following initial claims.
The near-term outlook is seen as remaining supportive for mortgages. For example, in research last week, UBS analysts said they were holding their overweight to the mortgage basis, noting that foreign buyers and total return investors should provide more than enough demand to absorb net new supply. Regarding the supply outlook for this year, they predicted net issuance in fixed rate agencies to fall 10% from 2006 to around $246 billion.
In their 2007 outlook, Barclays Capital analysts projected that for the next few weeks, mortgage spreads should benefit from lower volatility and foreign demand. Longer-term, however, spreads are at risk of widening due to a lack of bank demand, further curve inversion related to additional rate hikes, and a drop in volatility-driven returns, analysts said. They were also concerned about the possible repricing of discount MBS related to slowing prepayment speeds. Given these concerns, Barclays recommended a neutral weighting in MBS.
This week's economic calendar has several key releases scheduled, including Empire State Manufacturing on Tuesday; PPI and Industrial Production/Capacity Utilization as well as the Beige Book on Wednesday; and CPI, housing starts and the Philly Fed Survey on Thursday. There are several Federal Reserve speakers on calendar that would be offering their thoughts on the economy. On the mortgage calendar, Thursday begins 48-hour notification for Class C securities (30-year GNMAs) and on Friday for Class D.
Application activity jumps
The Mortgage Bankers Association (MBA) reported a jump in mortgage application activity for the week ending Jan. 5 as activity recovered from the holidays. The Refinance Index surged 17% to 1923.8. For the week ending Dec. 8, the index hit its highest level in over a year at 2304 as mortgage rates dropped to their lowest level since early last year. A year ago, the Refinance Index was at 1498. The Purchase Index also surged 16% to 472.8. This is the highest it's been since mid-January 2006 when it was at 473.7.
Caution is advised in reading too much into the activity numbers at this time of year due to the seasonal adjustments. Also, in regards to the Purchase Index, there is the possibility of double-counting going on, said Alec Crawford, head of agency MBS strategy at RBS Greenwich Capital. He noted that in the first week of the year, the rally lowered mortgage rates, allowing homebuyers the opportunity to lock in a new rate with a new lender and so be double-counted in the MBA's numbers. This should become clearer in the weeks ahead.
As a percentage of total application activity, the refinance share was up just slightly from the previous report to 48.4% versus 48.1%. ARM share slipped further to 20.1% from 20.4%. The sector's share in the application activity is the lowest it has been since July 2003, said the MBA.
Mortgage rates
see slight increases
Mortgage rates increased this week by one to three basis points as a result of the steady selloff since the non-farm payrolls report. According to Freddie Mac, the 30-year fixed mortgage rate increased to 6.21% from 6.18% last week. A year ago, the 30-year rate was at 6.15%, having declined steadily from the 6.30-area in early November.
The 15-year fixed mortgage rates recorded a two basis point gain to 5.96%, as did one-year ARM rates to 5.44%. The five-year hybrid ARM rate was little changed at 6.03% versus 6.02% previously.
Freddie Mac Chief Economist Frank Nothaft said that he expects mortgage rates to hold below 6.5% this year, and ARM rates to remain less attractive to borrowers. He added that his firm expects ARM share to fall below 20% for the first time since 2003.
Prepayment outlook
Initial expectations for January are for speeds to be little changed overall from December with slight declines anticipated for discounts and par and premium coupons increasing less than 5%. Factors influencing speeds include a higher day count - 21 days versus 20 days in December - and lower mortgage rates with the 30-year fixed rate averaging 6.14%, down 10 basis points from November's average. However, refinancing activity was slightly lower on average at 1880 versus 1919 because of the holidays.
Looking further out, February is projected to see a slowing of around 5% from January. Speeds in March are expected to jump around 20% as day count increases to 23 days from 21 days in February.
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