There is no end in sight for the current refinancing wave, as the mortgage market is expected to see the largest volume of paydowns over the coming summer months.
Art Frank, head of mortgage research at Nomura Securities International, said at a press briefing held last Thursday morning that prepayment speeds are going to be at levels never seen previously. For example, 30-year FNMA 5.5s are expected to hit 50 CPR while 30-year FNMA 6s would probably prepay at 75 CPR in July and August.
These unprecedented speeds are the consequence of mortgage rates remaining at all-time historical lows. In fact, Freddie Mac's Primary Mortgage Market Survey released last Thursday showed that 30-year rates only marginally increased to 5.24% from 5.21% the previous week, staying far below the 6.0 % level.
"Mortgage rates have never been this low since 1971 when Freddie Mac started reporting primary mortgage rates," Frank said.
Frank said that there is no end yet in sight for mortgage refinancings, as an above 4% 10-year Treasury yield threshold is needed to end the current refinancing boom. Even with the anticipated rise in Treasury rates - Nomura's economics department is forecasting 10-year Treasury rates to end the year at 3.75% from 3.45% as of last Thursday morning - the deluge in applications is only expected to slow a little.
In this environment, Frank said that investors are best served by dollar rolling in the lower coupons. Nomura specifically likes dollar rolling in 30-year 5s and 15-year 4.5s, which Frank said currently roll very well. He said that the lower coupons are now rolling special. For instance, if investors roll the whole year at 2/32s better than carry per month, this would mean an extra return of 75 basis points at the end of the year.
Frank said that there is demand for the lower coupons because dealers need to put them in CMOs. With so much demand for the lower coupons to go into the CMO machine, rolls have been trading through fail, or the effective cost of funds becomes negative, thus benefiting investors who roll. Frank also noted that the CMO sector saw the largest volume produced over the last few months. The steep yield curve from six months to three years has created a demand for short CMOs funded by overnight funds.
In the premium market, Frank suggests specialty pools as they still offer value versus the TBA market. He also recommended FHA/VA reperforming passthroughs that do not have the callability of their conventional counterparts but share the same credit characteristics as the loans guaranteed by Freddie Mac and Fannie Mae.
The general economic picture
At the same press briefing, Nomura's Chief Economist David Resler also spoke about his expectations for the second half of the year.
He said that Nomura has not changed its outlook and still envisions that the economy's recent sluggishness will end by mid-year. There are various factors now at work that were not in place last year. The stock market, for one, is beginning to recognize corporate profit. Furthermore, GDP growth is expected to gradually accelerate from a first-half average growth of roughly 2%. It is now predicted to rise slowly to a solid rate of expansion of 3.5% to 4% in the second half of this year, which is a pace that Resler judges to be "at or slightly above its long-run potential."
In his 2003 Mid-Year outlook review, Resler said that the optimism about the U.S. economy's improving performance is largely based on "crucial economic fundamentals" that are currently aligned to promote substantial upturn in economic activity. He added that increased government spending - particularly on defense and homeland security - along with newly enacted tax cuts have created an expansive fiscal policy that is expected to spur GDP growth by as much as 0.6% to 0.8% in the next 18 months.
Resler also noted the monetary policy remains accommodating. With a keener sense of the danger of further declines in inflation, he said that the Fed would more likely tolerate faster growth for a longer period more than it has in the past before it tries to apply the brakes. Aside from this, the weaker dollar should also help U.S. manufacturers in the initial stages of a recovering global economy. In addition, the considerable restructuring undertaken in a broad range of industries has started to revive corporate profitability.
However, before this optimistic forecast can come to fruition, Resler said that the employment picture has to improve to promote consumer spending. He said that consumers seem to have lost their appetite for new vehicles, while outlays for all other consumer goods and services are probably going to accelerate sharply once the tax cuts are implemented in the second half.
What about housing?
In terms of the housing market, there are increasing concerns that prices have risen too quickly and are currently over "fair value," thus increasing the risk of a sudden collapse of home prices. Resler said that housing as an asset should not be compared to equities, which are a subset of financial assets.
Unlike financial assets, "owner-occupied housing throws off a stream of services - shelter - that its owner would need to replace if the assets were sold," Resler wrote. "Moreover, improvements in the `quality' of the housing stock - e.g., energy efficiency, pre-wired telecom and entertainment systems, etc. - increase the value of those services."
He also noted that with home-ownership rates at historic highs, there probably is very little pent-up demand. He said that demand in both the real estate sector and home-building industries would likely slow to a pace that is consistent with long-run demographic fundamentals. However, moderately fewer sales and construction activity would not really jeopardize economic recovery.
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