After a strong month, profit taking picked up last week as the market traded off ahead of this week's Federal Open Market Committee meeting and as Asia prepared for public holidays to celebrate the Chinese New Year.
The week started off, however, on a strong note with solid buying from all investor types. Positives that got the week going included the lowest level of dealer inventories in 12 months; the recent FNMA 5% mega news that suggests there was heavy bank buying in the latter part of 2005 that settles in the first quarter 2006; and PIMCO's news that over 60% of its assets are in MBS. Also benefiting mortgages has been the favorable technicals, as supply has remained lackluster and the low level of volatility.
The factors attributed to the reduction in volatility include: a reduction in risk premiums demanded by bond investors; Fed policy transparency; strong mortgage market technicals, helped particularly by overseas buying; and discount dollar prices that have reduced refinancing risk.
Credit Suisse analysts expect these factors to continue.
The favorable backdrop to mortgages remains intact for the near term, and investors are expected to take advantage of this latest round of cheapening. Potentially supportive events coming up in the next week include month-end index buying and paydown reinvestment. Lehman Brothers forecasts the MBS Index to extend 0.08 years on Feb. 1. This compares to an average January extension of 0.09 years and a 12-month average of 0.08 years. Paydowns are estimated at $36 billion, according to JPMorgan Securities.
Most analysts are in the neutral camp at this time.
In its midweek report, JPMorgan turned "tactically neutral" on the basis from "tactically overweight." The firm suggests it may upgrade its view if there is more substantial widening. Bear Stearns upgraded its neutral/slightly negative tone to neutral as a result of declining dealer inventories and rising bank holdings of MBS.
UBS analysts are sticking with their modest overweight. They note that origination has been light while overseas has been supportive. Lehman remains underweight. It believes directionality will remain "pronounced" and the sector is likely to weaken significantly in a downtrade.
Mortgage application activity increases
Mortgage applications increased for the week ending Jan. 20, in response to the decline in mortgage rates, according to the Mortgage Bankers Association. The Purchase Index gained 6.7% to 473.7 and the Refi Index rose nearly 8% to 1773.9. As a percentage of total application activity, refinancings fell to 42.8% from 44%. ARM share was also lower at 29.5% versus 30.6%.
Freddie Mac reported a slight uptick in mortgage rates last week as rates backed up. Freddie's chief economist Frank Nothaft said, "The miniscule rise in mortgage rates this week most likely reflects market expectations that the Federal Reserve will once again raise rates next week."
After six straight weeks of declines, the 30-year fixed-rate mortgage rate increased two basis points to 6.12% for the week ending Jan. 27. On the ARM side, 5/1 hybrids were unchanged at 5.75% while one-year ARMs increased to 5.20% from 5.18%.
Since the start of the year, mortgage application activity has picked up in response to the more attractive rate levels. Since reaching a low of 1,259 the week ending Dec. 23, the Refinance Index has jumped 41% to 1,774, and is back to early November levels. With mortgage rates holding fairly steady this week, expectations are for further increases in the Refinance Index in this week's report.
Prepayment outlook
The January prepayment report will be out the evening of Feb. 6. Speeds are expected to decline 15% to 16% from December's levels. Speeds in February have been revised slightly higher as a result of the recovery in refinancing activity since the holidays. At this time, expectations are for speeds to increase about 5% from January's levels, and jump about 25% in March on the improved seasonals.
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