The wait for the Federal Open Market Committee's (FOMC) decision on Wednesday afternoon contributed to limited volume in the first half of the week.
On Monday and Tuesday, mortgages significantly underperformed the curve and swaps on overall better selling - particularly from servicers who were shedding duration following the recent backup in yields. On Monday, convexity-related selling reportedly totaled $3 billion. Adding to pressure that day was selling from hedge funds, insurance companies and banks, also in the lower part of the stack (5s and 5.5s), in part to move up in coupon.
While servicers remained better sellers on Tuesday, money managers and banks took advantage of the cheapening all along the coupon stack. Meanwhile, hedge funds were two-way. On Wednesday, mortgages opened strongly tighter with banks and hedge funds particularly supportive with down-in-coupon leading. At midday, 5s and 5.5s were 19 and 13 ticks tighter, respectively, to the curve. Mortgages came off their tights following the FOMC's expected decision to cut the fed funds rate to 1.00% as flows turned more two-way.
"The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures," the statement said. The FOMC said the inflation outlook was improved on the reduction in energy and other commodities, while the government's actions to help the financial system should help in time to improve the economy's prospects. "Downside risks to growth remain. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability" leaves the door open for further rate cuts. The decision was unanimous.
In other mortgage-related activity through midweek, originator supply averaged less than $1 billion per day, 15/30s were mixed, GNMA/FNMAs were little changed to tighter, dollar rolls weakened and specified pools continued to see better selling.
Month to date through Oct. 29, Barclays' MBS Index (formerly Lehman Brothers) was lagging Treasurys by 190 basis points. Still, this compares favorably to competing sectors: ABS negative 527 basis points, CMBS negative 867 basis points and corporates negative 597 basis points.
Mortgage Application Activity Rises
Mortgage application activity moved higher in the week ending Oct. 24 in response to lower mortgage rates. Freddie Mac's weekly survey reported that the 30-year fixed mortgage rate plunged 42 basis points to 6.04%.
The Mortgage Bankers Association reported that the Refinance Index rose 28.5% to 1489.4, more than offsetting the previous week's drop following the 52-basis-point jump in mortgage rates to 6.46%. The Purchase Index rose 8.5% to 303.1.
As a percent of total applications, refinancing share increased to 46.9% from 42.6%. ARM share slipped to 1.9% from 2.7%. This is the lowest ARM share based on data going back to late 2001.
At the current rate level, JPMorgan Securities calculated that refinance incentive increased to 30% of the mortgage universe from 8%. Despite the increased percentage, analysts don't expect this will produce a major spike in refinancing activity. For example, they point out that in September borrowers had a more attractive opportunity when the rate dropped to 5.78% and propelled the Refinance Index 88% to 2300. In addition, borrowers face increased constraints such as insurance costs, further declines in home prices, tight underwriting, etc.
JPMorgan analysts believe that refinancings will be stimulated at a 5.65% mortgage rate level that would push refi exposure of the market to over 50% and the Refinance Index to over 4000. That doesn't seem likely, however, until the Treasury's TARP program is fully up and running and experiencing successful results, along with some relaxation of the additional costs added this year by the GSEs.
Mortgage Outlook
Analysts remained in the neutral to positive range on agency mortgages last week. Citigroup Global Markets analysts, for one, held with a neutral basis position due to concerns about basis volatility and the effect of new government programs that they say favor other securities.
Bank of America analysts also retained their neutral weighting, citing uncertainty about the direction of implied volatility, the selling of agency bonds by overseas investors in July and August and dollar price levels. Regarding the latter, they noted that while MBS spreads are at similar levels to Oct. 14 - when the government announced its $250 billion plan to buy preferred stock in banks - dollar prices are higher. They say it isn't clear whether the GSEs, Treasury or banks will buy agency MBS at these higher prices.
Meanwhile, Barclays Capital analysts moved from an overweight on agency MBS to neutral and said they would buy only MBS with volatility hedged out. Their shift is partly based on the uncertainty of whether banks will use capital obtained from the Treasury to buy MBS and the unlikelihood that the GSEs will be buyers given their spread to funding is very negative. In addition, volatility has increased, which is a negative for the sector. On the positive side, it appears that the Treasury has been buying, while financing rates have started to improve.
JPMorgan analysts favored staying long the mortgage/Treasury basis on expectations that reduced supply, along with expected increased purchases from Treasury, GSEs and banks, should benefit spreads. They acknowledge, however, that the delay in implementing the government's programs has pressured the sector. Treasury is in the process of hiring asset managers, which apparently is taking longer than expected.
Prepayments in October are seen jumping nearly 50% in conventionals in response to the drop in mortgage rates in September and jump in refinancing activity following the government takeover of the GSEs. The largest percentage gains are in 6% and 6.5% coupons.
Meanwhile, GNMA projections suggest speeds increasing about 13% with the largest increases in 6s. Mortgage rates averaged 44 basis points lower to 6.04% in September compared with the average for the month of August, while the Refinance Index is up 64% to 1725.
The month also has one extra collection day. November speeds are expected to be down more than 10% from October's estimates. Contributing to the slowing is four fewer collection days.
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