The curve flattening and volatility decline that followed the Federal Open Market Committee raising interest rates to 3.75% last Tuesday has made many in the Street ambivalent about MBS. In its statement, the FOMC also indicated that it views the devastation caused by Hurricane Katrina and current higher energy prices as temporary setbacks, implying that it would continue its tightening bias going forward, causing some MBS analysts to fear future bank de-levering.
There are two ways at looking at the MBS market post-Fed. Although volatility - caused by uncertainty with regards to what the Fed is going to do next - is now out of the way, the market still has to deal with the flattening yield curve.
Bill Berliner, a senior strategist at Countrywide Securities, said that a flattening or inverted yield curve is never a positive event for mortgages. Two things occur simultaneously when this happens - lower forward rates imply faster prepayment speeds, and the resulting shorter cashflows are discounted to higher rates. And in a flatter yield curve environment "carry goes out the window," he said. As the spread between asset yields and funding levels shrinks, it becomes difficult for buy-and-hold investors to make money through carry, threatening to "take an important clientele out of the mortgage market," Berliner added. The lack of carry is also reflected in where rolls are trading, which is used as a proxy for the level of funding.
Although mortgages have cheapened to the point of not reacting to bad news, Deutsche Bank head of MBS research Amin Majidi said that the best-case scenario would have been if the Fed had indicated that it might stop tightening later in the year. "Obviously, a steepening of the curve and a greater likelihood of commercial banks buying mortgages would have really given the market a shot in the arm," Majidi stated. However, he added that Tuesday's news was ambiguous. On the one hand, the flattening of the yield curve was not helpful, with the higher coupons that are priced off the short end underperforming. But, on the other hand, the Fed's "more of the same" statement caused volatility to dip substantially. "The decline in vols allowed the lower coupons to keep pace with Treasurys and swaps quite nicely," Majidi stated.
David Montano, head of mortgage research at JPMorgan Securities, wrote in mid-week research that, although not surprised by the drop in volatility, the magnitude of curve flattening that followed the Fed statement was substantial, mostly offsetting the benefit from the dip in volatility for the basis. Despite this, JPMorgan analysts are maintaining their short-term tactical overweight. "We believe that in the near-term, low volatility will be more important as the pace of flattening subsides," Montano wrote, adding that Wednesday's bull flattening might have been technically driven with the market caught offguard by the Fed's statement and emphasizing that the move is easily reversible. Montano stated that JPMorgan's longer-term outlook for the basis remains negative as continued Fed tightening might push security de-levering from banks that are overweight mortgages, which is more likely to happen in late 4Q05.
Looking ahead, future Fed action would continue to be a huge factor in mortgage performance going into the next year. In the latest report from Countrywide Securities, analysts said that the bond market appears to be reaching an inflection point in terms of its outlook for the economy and Fed policy in the next year. One school of thought argues that economic growth will maintain its current pace or even accelerate, resulting in an upturn in intermediate yields. On the other hand, others believe that a consumer-led downturn in 2006 could cause the Fed to reverse its current course and ease in 2006.
Taken together, these opposite views might result in rate directionality in terms of the yield curve as well as interest rate volatility, Countrywide analysts said. In the short term, the market is geared up for a continuation of measured Fed policy, effectively anchoring the front end of the yield curve. This is happening in conjunction with debate about Fed policy over the next two years that is mainly being played out in intermediate and longer maturities. This results in a tendency for the curve to either flatten or invert if the bond market rallies or re-steepen in the beginning stages of a sell-off, said analysts. In terms of rate volatility, the market could be poised for another refinance wave that could result in active mortgage hedging, putting pressure on interest rate volatilities. An alternative scenario would be for the market to sell off mildly, raising mortgage rates to 6% or higher. This would, in turn, ease refi fears and cause a decline in volatility.
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