Last week should have been relatively uneventful. The market stayed within a narrow range with the limited economic news as well as a short trading week. In mortgages, there was the added anticipation that originators would be on the lighter side as many were attending the Mortgage Bankers Association National Secondary Market Conference and Expo in New York.
That wasn't the case, however, as the market steadily sold off. While the early part of the week contained no economic releases, the stock market continued to set new records and higher global rates were also weighing on the bond market. Thursday's better-than-expected increases in new home sales and durable goods orders supported the notion that the Federal Reserve will not be cutting rates anytime soon. In the first three trading days of last week, the 10-year Treasury lost 17+/32nds, while the yield rose 7.1 basis points to 4.859%. The yield level is the highest it's been since late January. Meanwhile, the 2s/10s curve reverted from slightly inverted to a steeper climb by Wednesday's close at 1.4 basis points.
In mortgages, volume was slightly above normal with the selloff. Flows were two-way and directed mostly up in coupon into 6s, as that coupon nears par and investors need to shed duration. Participation in this trade was widespread consisting of money managers, insurance companies, overseas central banks, and servicers. Asian investors, while not absent, continued to be a limited participant, focusing on the belly of the stack. As this trade gained momentum, it did encourage some limited contra trading from real and fast money moving into deep discounts. Originators were not so quiet after all, keeping daily average supply at between $1.5 billion and $2.0 billion. Supply was increasingly focused in 6% coupons.
Mortgages' excess return versus Treasurys continued to deteriorate. According to Lehman Brothers, the MBS Index is at negative five basis points month-to-date. This compares to 0 basis points for both ABS and CMBS, and 17 basis points over for corporates. Year-to-date, however, mortgages remain ahead of ABS and CMBS. Mortgages are at negative two basis points while ABS is at negative nine basis points and CMBS is at negative 31 basis points. Corporates continue to benefit from the strong equities and are up 24 basis points year-to-date.
Mortgage outlook
After a light week on the economic data front, news will pick up in the last week of May with the highlight being the May employment report released on Friday. Other releases include Consumer Confidence on Tuesday; the ADP Employment Report and Federal Open Market Committee minutes on Wednesday; the preliminary first-quarter GDP, Chicago PMI and Construction Spending on Thursday; and Personal Income/Outlays, the final May Michigan Sentiment reading, the ISM Index and the Pending Home Sales Index on Friday.
The week includes two events that can be supportive for mortgages: month-end and nonfarm payrolls. According to Lehman, the MBS Index is estimated to extend 0.14-years on June 1. The MBS extension is a little below the May average. Still, due to the increase in duration caused by rising rates, the new MBS duration has risen all the way to 3.80 years compared to only 3.56 years to end April. Also, volatility tends to drop following the release of the employment report, which is usually favorable for mortgages.
A supportive tone is anticipated in MBS below 4.85% on the 10-year; however, as it moves toward 4.90%, there are increasing market concerns of duration shedding from servicers. In a recent report, RBS Greenwich Capital analysts said they expect to see significant selling pressure from servicers if the 10-year hits 5%, along with FNMA 6s dropping below par to the 99-16 handle. As of midday Thursday, FN 6s were at 99-31. The firm's model projects this level would trigger $50 billion of UST 10-yearequivalent selling. At midday on May 24, the 10-year Treasury was at 4.883%. At some point, though these higher yield levels should start drawing in good buying support.
Street analysts last week were mostly in the neutral camp. Primary concerns continued to be the heavy supply and limited demand. Credit Suisse analysts noted extension risk as well as the potential for volatility to spike up additional concerns. Barclays Capital noted 1Q07 bank data pointed to slower deposit growth that could slower the MBS bid.
Bear Stearns analysts still believe that owning MBS against swaps looks better than owning them against Treasurys. This is because slowing issuance in Treasurys and concerns about corporate credit increase the risk that spread product could lag Treasurys. Factors favoring MBS, they said, are good prospects for volatility remaining low ahead of the June 28 FOMC meeting and good financing in the dollar roll market. The limited demand is a concern, particularly with the increasing supply. However, Bear Stearns analysts anticipate that foreign sponsorship should improve as reserves continue to build.
Application activity increases
Application activity increased 1.6% overall for the week ending May 18, despite higher mortgage rates. Expectations were for activity to move lower. Countrywide Securities, in fact, reported that its activity was down in that week, with refinancings slipping 3%.
According to the Mortgage Bankers Association, the Refinance Index rose 1.9% to 2154.7. This is the highest the index has been since the week ending March 23 when it reached nearly 2200. A year ago, the index was at 1481 with 30-year mortgage rates hovering near the 6.60% area. The MBA also reported a 1.3% gain in the Purchase Index to 438.1. Last year at this time, the index stood at 396.
On the latest application activity, Lehman Brothers economists last week said that this brings another week where the data suggests a stabilization of activity, along with a shift in preference for fixed-rate mortgages. If both of these are sustained, it would be good news for the economy, they said. The new home sales report from April also suggests potential stabilization in the housing market. For example, new home sales rose by more than expected to 981,000 versus expectations of 860,000. Furthermore, new home sales were up in the Northeast, South and West, with only the Midwest declining. While median home prices fell 11.1% in the past month, inventory levels declined to 6.5 months from 8.1 months.
The MBA also reported that as a percent of total applications, refinancing share was little changed from the previous week at 42.3% versus 42.1%. ARM share, however, increased to 18.1% from 17.4%. Lehman's economists noted that ARM share has been below 19% for seven weeks and is currently at less than half of the level of ARMs at their peak. Between this and performance of the Refinance Index in the past year (up 45%), "This suggests that borrowers are actively attempting to stave off sizeable increases in their payments related to adjustable-rate mortgage resets and is a positive for consumption growth going forward," said the economists.
Mortgage rates rise sharply
Fixed mortgage rates jumped sharply this week as the market has been on a steady selloff. According to Freddie Mac's survey, 30-year fixed mortgage rates surged 16 basis points to 6.37%. This is the highest rates have been since late October 2006. A year ago, 30-year fixed rates were averaging 6.62%.
Freddie Mac Chief Economist Frank Nothaft attributed the rise in rates to stronger-than-expected consumer confidence, along with recent comments from Federal Reserve officials that have lowered expectations of a Federal Reserve rate cut this year. He added that they expect a gradual increase in mortgage rates over the remainder of the year with sales slipping further in the second half. Toward the end of the year, he anticipates a gradual recovery with modest increases in sales and construction during 2008.
In 15-year fixed-rate loans, the rate rose 14 basis points to 6.06%. Last year at this time, the rate was at 6.23%. On the adjustable side, five-year hybrids increased to 6.02% from 5.92%, while one-year ARM rates also jumped 16 basis points to 5.64%.
Given the sharp increase in mortgage rates, mortgage application activity is likely to have slipped last week. The looming Memorial Day holiday is also expected to have some impact on activity.
Speeds in the May prepayment report are expected to go up about 10% from April's level. Contributing to the rise is a two-day increase in the number of collection days and improving seasonals. Currently, speeds are expected to remain almost the same in June and July. Day count in both months is 21 days, which essentially offsets the further slight gains from seasonals. -
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