Despite the lower mortgage rates seen in recent months, MBS analysts across the Street are still expecting limited supply in the near term.

Fixed-rate mortgages edged lower to new record lows in the week ending July 22, with Freddie Mac's weekly survey reporting 30-years at 4.56% with an average 0.7 point. This equates to a no-point rate of about 4.74%.

Lower rates are stimulating refinancing activity. The Mortgage Bankers Association reported that for the week ending July 16 the Refinance Index jumped nearly 9% to 4161 - its highest level since mid-May 2009.

In recent research, Morgan Stanley analysts said that the better credit quality borrowers are finally beginning to take advantage of the historically attractive rate levels. If rates decline further, this would increase the incentive for borrowers to "continue to take advantage, and this index (Refi) is likely to continue to climb higher," according to analysts.

Gross supply is picking up as a result of the decline in mortgage rates and pickup in refinancing activity. JPMorgan Securities analysts estimated that it could reach $130 billion to $140 billion by September/October, up from $90 billion in June. Meanwhile, they estimate net organic supply at $20 billion to $25 billion two months out as paydowns/prepayments pick up. There will also be additional net supply from run-off from the Federal Reserve's portfolio, analysts added, that will have to be absorbed by the private sector.

Overall, however, JPMorgan analysts project 2010 net issuance to be flat in agency MBS.

In addition, analysts expect an overall decline in the securitized products market of $374 billion (negative $100 billion in ABS, negative $239 billion in non-agency MBS and negative $35 billion in CMBS).

In their base case, Morgan Stanley analysts' most recent estimate on agency MBS net supply is negative $110 billion in the second half of 2010. If rates continue to rally with 4.5s responding, they think net supply from refinancings out of the Fed's portfolio would be around $38 billion per month, which would turn net supply positive, "but still historically low," they said.

Overall, however, as suggested in the different supply outlooks discussed above, technicals are expected to remain favorable for mortgages.

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