In a recent report, Goldman Sachs compared the current mortgage market environment to that of the 1997 period. The firm believes the same factors were present during that time: actual volatility was subdued, implied volatility weakened steadily, and mortgages traded “rich” for a sustained period.
However, this time around, the story is reversed. In 1997-98, the storm of October 1998 ended the calm that preceded it. Today it’s the storm that has preceded the calm. Goldman notes that the recent July-August dislocation has now given way to a new trading range. Analysts examined whether this analogy could justify the current environment’s historically rich levels.
Mortgages became rich for a sustained period between mid-1997 and mid-1998 before cheapening to “fair value.” This is the only period in recent history where mortgages traded “rich” vs. historical valuations consistently over a year. Goldman said mortgages look quite rich in the current period as well.
Another similarity between 1997 and the current environment is the level and stability of pricing in the mortgage market, analysts said. They noted that mortgage prices appeared relatively stable during 1997 to 1998, hardly leaving the 102 level. Today, the market is also bouncing around 102.
Volatility was on a strong downward trend from 1997 to 1998, before the rude awakening of October 1998. Currently, volatility seems to be on a similar path. Marginal buyers of mortgages are shifting to institutions that hedge volatility more efficiently to those that are less efficient. As a result, with lesser aggregate demand for options to hedge mortgages, it is reasonable that volatility continues to fall, particularly if rates stay range-bound.
A difference between the two time periods is the shape of the curve. The 1997-1998 curve was essentially a pancake in comparison to today’s steepness, Goldman said. However, the curve actually exhibited a flattening trend from 1997 to 1998, similar to recent experience. As investors become more positive that monetary policy will remain on hold for a while longer, they become increasingly willing to reach further out the curve for yield. Analysts said that even if the curve followed the 1997 precedent, they don’t think this would have a very significant effect on mortgage valuations.
All in all, Goldman says mortgages look rich historically, whether you weigh recent data more heavily than less recent data, or vice versa. However, the range has been good to mortgages. The Fed being on hold and banks experiencing zero loan growth could contribute to lower implied volatility and to further tightening in mortgages. Analysts think that the ghosts of 1997 remain alive and well, which could keep mortgages on the rich side.