Treasurys sold off sharply during the week through Thursday primarily as a result of some better-than-expected economic news such as retail sales and industrial production which unwound some of the QE3 premium.
Addiontally, supportive comments from the Chancellor of Germany Angela Merkel on the European Central Bank's plan encouraged some risk-on trades.
By Thursday's 3:00 marks, the 10-year note yield had backed up 19 basis points from last Friday to 1.836%, its highest level since early May, and since hitting a record low 1.404% in late July, the yield has surged over 40 basis points.
While the QE3 probability declined, it still is above its lows of the spring when odds dropped to between 20% and 30%. For example, Credit Suisse's metric had odds at around 49% which is down from the upper 70s as of the prior week.
Meanwhile, BNP Paribas' measure suggested odds remained above 60%, but down from around 80% in July.
The sell-off, of course, contributed to increased mortgage banker selling, particularly midweek when it reached nearly $4 billion. On a daily average basis for the five days ending Thursday, however, supply was relatively normal at $2.3 billion and unchanged from the prior week.
At the start of the week, investors were still opportunistically buying down in coupon specifically as hedge funds and money managers took profits on 4.0% through 5.0% coupons. These trades were partly based on some chatter that the Federal Reserve might engage in a "mortgage twist" operation, or selling higher coupons in its portfolio and buying production coupons.
By Wednesday, however, the tide turned and hedge funds, servicers, REITs, money managers and overseas heavily sold production coupons as rates continued to back up and QE3 odds lowered. The cheapening, though, brought back a wide range of real and fast money buyers by the final two days of trading for the week.
The Fed remained a steady buyer at a daily average of $1.32 billion on net which covered less than 60% of the supply. For the week ending August 15, the Federal Reserve Bank of New York reported gross MBS purchases of $8.35 billion and $1.75 billion in dollar rolls primarily in FN 3.5s and to a smaller extent in GN I 3.0s.
As trading got underway on Friday, Treasury announced modifications to its Preferred Stock Purchase Agreements (PSPAs) with the GSEs which led to some knee jerk fast money selling that quickly quieted down.
BNP Paribas MBS analysts said that with the Fed as a key player in the sector, "this shouldn't have a perceptible impact", while some traders perceptions were that while Fannie Mae will have increased pressure to reduce its portfolio, it's not expected to have a large impact on the TBA market and also that it is not something the market should be too concerned with at the moment.
A Barclays Capital report suggested that the current pace of liquidations in the sector should allow Fannie Mae to reach the $650 billion cap by year-end without having to resort to outright sales. In addition, their view was that the modifications make the GSEs more dependent on the government and so they will essentially be seen as off-balance-sheet government entities.
Should the financial regulators agree, the risk based capital weights could be reduced eventually which could increase investor demand for their debt securities. They, as well as, others on the street also said this could weaken support for GN/FNs over time.
In other mortgage related activity, 15s mostly outperformed 30s as the yield curve steepened around 16 basis points on the 2s10s curve by Thursday, while GNMA/FNNAs struggled on rich levels and supply. Specified trading also seemed quieter as a result of the back-up. However, there is still demand for call protected paper.
Volume was above average for the week as a result of the sell-off with Tradeweb averaging 124% compared to 90% previously. Excess return to Treasuries was -8 basis points on Barclays MBS Index with MTD performance at +9 basis points. The 30yr Current Coupon yield surged 24 basis points to +2.70% with the spread to 10-year notes widening five basis points to +86.
The early part of this coming week has no economic data or key events which suggests very slow and illiquid markets. On Wednesday, however, the Federal Open Market Committee (FOMC) Minutes from the July 31-Aug. 1 meeting is released and participants will be looking for insights about QE prospects for September. For most of the year, FOMC statements and minutes have led to significant fluctuations in quantitative easing odds.