Mortgages are off to a rough start in May primarily due to all the curve gyrations and yield backup. This was caused, in part, by Federal Reserve Chairman Ben Bernanke's comments to CNBC correspondent Maria Bartiromo at a White House Correspondents dinner, and in part by stronger-than-expected economic data. The Fed Chairman clarified that the markets had misinterpreted his remarks at his recent appearance before the U.S. Congress Joint Economic Committee.
Through the first three trading days of last week, Lehman Brothers' MBS Index recorded an excess return versus Treasurys of negative 11 basis points, nearly wiping out April's gains of 14 basis points. Flows throughout the week were fairly active, two-way, and directed up-in-coupon. While there was some servicer rebalancing, it continues to remain limited. The week also saw the absence of Asian support as that region was on holiday for Golden Week celebrations.
Originator selling continues to hold to a daily average of $1 billion or lower. Supply, however, is increasingly focused in 6.5% coupons and is affecting the roll. In early trading on Thursday, it was at 3.625 compared to over 5.0 in recent weeks. JPMorgan Securities analysts believe issuance will reach at least $9 billion per month by the summer for FNMA 6.5s.
Mortgage sentiment over the near term remains mostly neutral at this time. Technicals remain favorable with limited supply, and ongoing support is expected from banks, overseas, and even some from the GSEs. If the Fed should pause, it is also seen as favorable for mortgages. According to Lehman analysts, this should lead to a further reduction in volatility and spreads would likely tighten. The researchers prefer up-in-coupon and IOs as these sectors should benefit from such an outlook. Higher coupons and IOs should also be less negatively impacted if the Fed needs to continue to raise interest rates after pausing in order to keep inflation in check.
In their mid-week comments, JPMorgan analysts upgraded their recommendation to neutral from underweight as a result of the recent widening in the sector versus swaps. "While mortgages don't look particularly attractive on a fundamental basis, spread product across the fixed income spectrum is tight, and mortgage supply is muted," they said.
Although May has not been good to mortgages so far, the outlook is anticipated to start to improve sometime this week. Asian investors will be back from their weeklong holiday. Also, many investors are expected to take advantage of anticipated better yield opportunities caused by the Treasury Refunding supply and the Federal Open Market Committee. On Tuesday, the Treasury is scheduled to auction $21 billion three-year notes, and on Thursday, $13 billion in 10-year notes. The FOMC meets on Wednesday and will release its statement at 2:15 PM.
Application activity rises
Despite the strong gains in mortgage rates, application activity is holding up better than expected. A large contributor to this is the attractive locked in home price appreciation that borrowers are extracting in order to consolidate home debt that is tied to the prime rate. This was demonstrated very clearly by Freddie Mac's recent report on first quarter cash-out refis, which clocked in at 88%, the highest quarterly level in 15-years (see related story p.14).
In the latest survey from the Mortgage Bankers Association, it was reported that mortgage application activity rose 8.8% for the week ending April 28, with the Refinance Index gaining 5% to 1566 and the Purchase Index surging 11% to 433. These levels are the highest since March 31.
As a percentage of total application activity based on dollar volume, refinancings declined to 35.9% from 37.10%. ARM share, meanwhile, rose to 41.4% from 40.7%.
Mortgage rates hold steady
Despite the move higher in interest rates last week, mortgage rates held little changed from the previous week, according to Freddie Mac's survey. For the week ending May 5, the 30- and 15-year fixed mortgage rates rose just one basis point to 6.59% and 6.22%, respectively. Still, fixed mortgage rates are at their highest level since around mid-2002. On the ARM side, 5/1 hybrids were unchanged at 6.21% and one-year ARM rates slipped one basis point to 5.67%.
Expectations are for mortgage application activity to move lower in the coming weeks due to increasing mortgage rates; however, debt consolidation may keep refinancing activity from declining as fast as might be expected.
Freddie Mac's chief Economist Frank Nothaft noted that mortgage rates have drifted up for the sixth consecutive week, remaining consistent with the GSE's forecast. "We expect that the mortgage rates will continue to trend upward over the coming year, but that upward trend will be modest at best," he said.
Higher rates are also going to affect the kind of refinancing activity that the market is going to see. "With gradually rising rates, refinance activity can be expected to shift." He explained that fewer families will be refinancing, and of those who are, a bigger portion will be drawing some equity out of their homes to pay off previously existing home equity loans and lines of credit as those loans become more expensive.
April prepayment reports for conventional mortgages will be out last Thursday evening, with GNMAs released last Friday. Speeds are expected to decline about 8% to 10% from March. As has been reported, the decline in day count to 19 from 23 is the primary reason for the slowing in speeds as refinancing activity was down just slightly on average. JPMorgan analysts estimate paydowns will total $37 billion, down 6% from March.
In his monthly prepayment outlook, Bear Stearns' Senior Managing Director Dale Westhoff says that in the second half of 2006, prepayments "are likely to be slower than they have been since prior to the 2003 refinancing event." At current rate levels, only about 7% of fixed rate borrowers have some refi incentive. He adds that the majority of these eligible borrowers holds a 6% mortgage, but faces a 60 basis point give-up in rate if they decide to take out a new 30-year mortgage. Standard hybrid ARM options also have limited attractiveness with a give-up ranging from 25 to 60 basis points depending on the type, says Westhoff.
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