Excerpted from a larger report by Arthur Q. Frank, head of MBS Research, Nomura Securities
As we look at the new year, the MBS market appears on the verge of another refinancing wave that is priced into the market.
While traditional practices suggest that prepayment fears may be a bit exaggerated in premium passthrough and IO Strip prices, the mortgage market has proven the ability to change the dynamics of refinancing.
Because both current mortgage rates and the slightly lower mortgage rates forecast for 2001 by Nomura Securities International's Economic Research Department are considerably higher than the generational low in rates of late 1998 and early 1999, we expect the upcoming 2001 refinancing wave to be comparable in premium coupons to the 1998-99 experience, and fairly mild in current coupons.
We believe that the steeper Treasury, agency, and swap curves that we expect as the Fed eases bode well for the performance of MBS as a sector over the next several months, but if in the near term the bond market continues to rally, we may well see some underperformance.
In addition, swaption volatility continues to play an integral role in the MBS term structure. We expect volatility to soften in the coming year, but it will be in conjunction with the easing of monetary policy.
The MBS market is priced a bit on the inexpensive side compared to agencies, swaps, and Treasuries, but not compared to high quality corporate bonds. We therefore suggest a modest overweight of the MBS market for all but the most bullish investors.
Refi Wave, Steepening Curve
The recent bond market rally has priced in the slowing economy and begun to anticipate some accompanying Fed easing.
This bond market adjustment has come quickly. Now that it has occurred, the NSI Economic Research Department interest rate forecast, which calls for 7% mortgage rates by late 2001, traces a trading range for those rates throughout the year. This should be an environment generally favorable for the MBS market.
Initially, with the drop in mortgage rates to just above 7%, a refi wave looks to be in the making. But unlike the 1998-99 experience, it is likely to be fairly mild in current coupons but comparable in premium coupons and adjustable rate mortgages. Moreover, as the Fed actually eases in the winter and spring, the yield curve should steepen, supporting the MBS market.
It is difficult to ignore the fact that current coupon MBS spreads to swaps and agency benchmarks are quite wide by historical standards, and that volatility tends to decline as expected Fed eases become reality.
The market has already started to discount a refinancing wave, but there are two schools of thought on the subject. First, nearly two-thirds of the passthrough market is currently comprised of coupons of 7% and below. In 1998, by contrast, 55% of the market consisted of 7.5% passthroughs and higher.
Thus, with 7% mortgage rates, the prospective refinancing wave should be much less dramatic than 1998-99. Then, as well, mortgage rates were reaching lows not seen in nearly 30 years, a development that generated intense publicity. Now, current rates are only the lowest in 1-1/2 years, a much less exciting event likely to attract little media attention.
Through December 22, the Mortgage Bankers Association of America (MBAA) Refinancing Index has seen quite modest increases to just 794, compared to 4,389 at the mid-October peak of the 1998 experience. However, the recent muted increase may be largely an artifact of the December holiday season, and Refi Index is likely to run well above 1,000 by the second week of January.
By March resulting prepayment speeds could reach the mid-20s CPR on conventional 8s and the mid-30s on conventional 8.5s. These are, of course, far short of the 50 CPR level reached on 8s two years ago. The combination of a more muted media effect plus a much smaller refinanceable universe for mortgage originators to target should keep premium speeds below their 1998-99 peaks.
The Yield Curve
The slope of the yield curve is another important force on the selection of mortgage securities.
As the Fed moved to an easing bias at the December 19 FOMC meeting, a market consensus has developed favoring steeper Treasury, agency, and swap yield curves in the crucial 2-to-10-year segment. Steeper yield curves are a positive for MBS generally, as lower short-term rates make the shorter cash flows of MBS worth more fundamentally, and a steeper curve potentially improves CMO execution, assisting market technicals.
The 15-year sector benefits from a steeper curve from 2s to 10s more than the 30-year sector. However, swaption volatilities complicate this relationship. Historically, implied volatility has tended to decline once the Fed actually begins to lower the fed funds rate.