While fears of inflation, prompted by an unusually high index number from the National Association of Purchasing Managers (NAPM) early in the week, sustained the overall uncertainty in the bond market, a major sell-off in mortgage securities provided a good opportunity for some buyers last week.

"All of the worries regarding economic numbers and interest rates have been benign," said Michael Youngblood, managing director for mortgage securities at Banc of America Securities. "Spreads have actually come in since the week before."

According to Youngblood, the nominal yield spread of current coupon Fannie Maes had narrowed by six basis points on the week. As of May 24 the nominal spread was 131 over Treasurys, but as of June 1, spreads had narrowed to 125 over. This represented better performance than interest rate swaps, Youngblood added.

"The mortgage market has yet to fully reflect the likelihood of longer durations and to adjust spreads accordingly," Youngblood said.

Over the course of last week, empirical durations, which are based off actual prices, had begun to lengthen by 2/10 to 3/10 of a year across coupons. For example, there had been a 10% lengthening for Fannies with a 7% coupon, and a 15% lengthening for Fannies with a 7.5% coupon.

"The market is moving to express in price movement longer durations on mortgage securities, so these spreads will widen," Youngblood said. "But this week, notwithstanding all other factors, yield spreads have come in."

A total NAPM index of 55.2 - the highest since October 1997 - raised concerns that the Fed will tighten sooner rather than later, sources said. This was the fourth month in a row that the NAPM number was above 52, and it represents that orders are strong in an expanding manufacturing sector.

"It shows that there is an overheated manufacturing sector, or at least a move toward overheating," said Art Frank, an MBS researcher at Nomura Securities. "But I think that people are generally overreacting to the number."

Following four consecutive monthly declines, sales of new homes unexpectedly increased 9.2% in April to a seasonally adjusted annual rate of 978,000 units, the Commerce Department said last week. These new home sales confirmed that the housing market continues to be strong, sources said. In response, mortgage rates were pushed higher this week.

The 30-year fixed-rate mortgage rate was 7.41%, a sharp increase from the average one week earlier, which was 7.23%. While fears of extension risk abound, the rate increase didn't seem to bother some mortgage players.

"Typically, in a bear market, mortgage collateral is one of the best things to own," said an MBS portfolio manager. "It is a safe haven for investors worried about interest rates because they get their principal back at par. Most of this year, mortgages outperformed U.S. Treasurys."

Despite the rising interest rate environment, sources say, there have been stronger economic numbers, high employment, and a very strong consumer demand for new homes. However, the volatility in the Treasury market has caused a little bit of swap spread widening.

"But to be honest, the corporate market has been worse," said the MBS portfolio manager. "That market is a lot softer than the mortgage market, and there has been a significant widening in corporate bonds and in Yankee issues."

- AT

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