Mortgage flows started off on the quiet side last week as the market waited for the Fed's economic commentary. Activity picked up shortly after, as the market rallied on the favorable wording: "policy accommodation can be maintained for a considerable period." In comments from Lehman Brothers' economists, they believe the Fed will hold rates unchanged through 2004 "as the ongoing recovery takes a long time to close the output gap and inflation remains subdued." The lower coupons benefited from the news due to carry and curve steepening.

Mortgages continued to tighten in early trading on Thursday as the market sold off following the stronger-than-expected third quarter GDP report. Technicals are supporting the market as originator selling has averaged about $1 billion per day. In addition, the week saw some month-end buying from indexers. According to Lehman, the MBS Index is expected to extend 0.24 years in October. While down from the 0.30- and 0.36-year extensions seen this summer, it is still large by historical standards. Other sectors are predicted to show more moderate lengthening. For example, the Treasury Index is anticipated to gain just 0.01 years, the Agency Index 0.02 years, and the Credit Index 0.07 years. Overall, the Aggregate Index is forecast to rise 0.11 years.

Analysts are neutral to underweight the sector given the rich valuations. The coupons most favored are 30-year 5.5s and 6s versus 5s and 6.5s, and 15-year 5s and 5.5s. Lehman remains underweight on concerns that the market is not pricing in the recent increase in implied volatility. While they agree bank demand has been strong of late, that alone does not justify current valuation levels, they say. They recommend investors replicate a mortgage using a combination of swaps and swaptions. The advantage of the strategy is that it neutralizes the position against any movements in implied volatility.

Over the Wednesday-to-Wednesday period, spreads tightened five and four basis points on 30-year Fannie Mae 5s and 5.5s, respectively. Meanwhile, 6s and 6.5s were three basis points firmer. Dwarf 4.5s were also five basis points stronger, with 5s and 5.5s in three basis points.

Refi Index rises as mortgage rates fall

Mortgage applications were mixed for the week ending Oct. 24. According to the Mortgage Bankers Association (MBA), the Purchase Index fell 6% on a seasonally adjusted basis to 364; however, the Refi Index rose 5% to 2311. This was in line with analysts' expectations. As a percentage of total applications, refinancings were 53.3% versus 50.5% in the previous report. ARM share rose to 26.5% from 26.2%.

According to Michael Cevarr, MBA's manager of member surveys, "the ARM share of applications is at its highest in over two and a half years." He explained "with little expectation of an increase in short-term rates in the near term, borrowers are reacting to the continued large spread between adjustable and fixed rates."

As for the application outlook, Lehman believes that given the highly skewed coupon distribution of the mortgage universe, upward movement in the Refi Index will be subdued, even if rates rally from current levels. The firm expects the Refi Index to remain below 3000 in coming weeks.

Citigroup Global Markets adds that with the spread between the primary and secondary markets tighter, lenders have enough capacity to process incoming applications without a substantial backlog. In addition, these lenders are willing to operate at tighter margins to attract more applications. This suggests the Refi Index will continue to hold above the 2000 area.

As expected, mortgage rates fell for the week ending Oct. 31. According to Freddie Mac, the 30-year fixed rate mortgage rate declined 11 basis points to 5.94%. The 15-year fixed rate mortgage reported in at 5.26% versus 5.39% last week. And lastly, the one-year ARM rate was 3.74%, two basis points below last week's level.

Looking ahead to the October prepayment report - which is due to be released on Nov. 7 - consensus anticipates speeds to slow around 15% to 20% for 30-year 5.5s through 6.5s. November's slowing is predicted to be in the 5% to 10% area, while December is expected to be unchanged to slightly higher from November.

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