From Aug. 14 through Aug. 16, the MBS Index added 12 basis points in excess return versus Treasurys as the market rallied sharply following the better-than-expected inflation reports, according to Lehman Brothers. Month-to-date through Aug. 16, the MBS Index is up 27 basis points. Meanwhile, year-to-date, mortgages have outperformed by 79 basis points. For all of 2005, mortgages underperformed by 37 basis points.
Last week saw substantial buying in MBS from a wide range of investors, including Asian buyers who finally showed up on Wednesday. Buying on Tuesday and Wednesday was said to offset selling by a ratio of 3:1. In particular, servicers were actively selling 6.5s to move down in coupon, specifically 5s, to add duration.
"The biggest theme over the past few days is mortgage servicers (who have probably been short MBS, rates, and vol) chasing the rally," said Alec Crawford, head of agency MBS strategy at RBS Greenwich Capital, in midday comments last Thursday. "They have been buying the mortgage basis, buying mortgages outright, doing down in coupon trades (weighted and even dollar), and probably receiving in swaps as well. We have not seen option buying or yield curve inversion trades directly, but these are also possibilities."
JPMorgan Securities analysts estimated that every 10 basis point rally should drive about $6 to $7 billion of 10-year equivalent purchases, assuming 50% of duration needs have already been covered by option positions. They added that in the recent rally hedging needs have been around $5 to $10 billion per week over the past month, which has helped drive the rally further.
Other fast money played it both ways, taking advantage at times of the cheapening in 6.5s on the servicer selling, and buying 5s in anticipation of further interest from servicers. Real money generally remained focused in 5.5s and 6s. While flows were directed more towards buying, hedge funds and others did take profits following bouts of strong spread tightening. Originator selling generally averaged over $1 billion per day last week.
Despite the tightening in spreads and less attractive fundamentals, the outlook for mortgages appears favorable currently. The sector is seen as directional with the market given the current environment and interest rate levels. The favorable technicals also remain a source of support for mortgages. Street analysts' preference remains up-in-coupon.
Longer term, there is anticipation that spreads could reach new tights. According to RBS Greenwich's Crawford, in 2000, after the Federal Reserve finished tightening, mortgages did eventually reach new tights in the months following. In addition, there is talk starting to emerge about the Fed easing at some point in 2007, which is a favorable outlook for mortgages.
Despite the jovial tone in mortgages, JPMorgan strategic principal trader David Montano is concerned about the potential for a "major rate whipsaw." Worrisome to him is the potential for volatility to tick higher if the market continues to rally, and that further declines in rates will lead to higher refinancing activity and thus higher supply, then followed by a less encouraging CPI number in September, causing a sharp sell-off.
Refinance Index gains
The Mortgage Bankers Association reported last week that mortgage application activity rose 1.4% for the week ending Aug. 11. As expected, purchase activity was slightly lower, while refinancings were modestly higher. The Refinance Index rose 4.6% to 1587.5. This is the highest the index has been since the end of March, when it was over 1600. Meanwhile, the Purchase Index slipped less than one percent to 385.9, compared to 388.9 in the previous report.
Mortgage rates slipped further last week, according to the latest Freddie Mac mortgage rate survey. The 30-year fixed mortgage rates averaged 6.52%, down three basis points from the previous week. Since July 21, mortgage rates are down 28 basis points, and are at their lowest level since mid-April. The survey reported 15-year mortgage rates held steady at 6.20%, while 5/1 hybrid ARMs and one-year ARM rates fell three and four basis points, respectively, to 6.18% and 5.65%.
With the inflation-inspired rally last week, refinancing activity is expected to have continued to gain last week with a print near 1700 anticipated. JPMorgan's Montano, however, said a 15% to 20% increase to over 1800 in the Refinance Index would not be a surprise. Such a print would put the index at its highest level since early November of last year.
Freddie Mac Chief Economist Frank Nothaft noted that last week's news that July housing starts fell vindicated Fed Fund futures traders who are now pricing contracts to suggest that the chances of an additional rate increase from the central bank this year are about 50-50. This market expectation has resulted in 30-year fixed-rate mortgages being down for the fourth consecutive week, which is the lowest they have been since last April.
Potentially contributing to the rise in refinance activity is ARM to fixed refinancings. Nothaft pointed out that ARM rates have declined less than fixed rates which "could help persuade homeowners with ARMs on the verge of resetting to make the decision to lock into a fixed-rate mortgage now rather than take a chance of a higher rate on the adjustment date."
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