Last week's highlight was the explosion of the 6% and FNMA 6.5% rolls. Monday was pool notification and both the FNMA and Gold FHLMC rolls moved as high as 6/32s, and FNMA 6.5s went to 10/32s. This encouraged flows to move up in coupon over the week.
While supply is increasing in 6s, there's likely still to be an imbalance next month, market participants said. As a result, the roll is expected to remain firm. A similar situation is expected with 6.5s.
Overall, however, flows were relatively quiet as there was no data at the start of the week to influence trading direction, and the end of the week saw a short trading session and a full holiday.
Sentiment remains neutral to negative. Mortgages are fairly sensitive at this point with concerns of servicer selling if the 10-year backs up to 5%. Asia has also been less supportive than anticipated so far this month. One analyst noted, however, that there was interest in profit taking by overseas if the 10-year falls below 4.90%.
Last Tuesday Alec Crawford, managing director and head of agency MBS strategy at RBS Greenwich Capital, said that they offered bonds to Asia overnight, but the prices were considered by investors to be too high. "We suspect a move to 5% U.S. Treasury would allow Asia to buy some bonds," Crawford said. "However, they will probably wait for servicers to sell and watch for the start of a rally before they buy."
Other negatives for mortgages include high dealer inventories, and a break in the 10-year Treasury trading range. JPMorgan Securities analysts noted this previously and said it could push volatility higher as well as lead to portfolio rebalancing. On the positive side, supply remains manageable at $1 billion or less per day.
Mortgage application activity falls
As expected, mortgage applications dropped off for the week ending April 7 as mortgage rates reached their highest level in 2.5 years. The Mortgage Bankers Association reported that the Purchase Index was down 4.7% to 418, while the Refinance Index dropped 6.6% to 1532. Expectations are for the Refinance Index to fall through 1500 in this week's report due to further gains in mortgage rates.
With higher mortgage rates, there has been some anecdotal evidence of cracks in the housing market, analysts said. According to RBS Greenwich's Crawford, one of the better real-time indicators of housing is perhaps the home builder stocks. He said that volume is slowing down and inventories are rising, particularly in "investor driven" markets such as Florida. "We still think the overall housing market will have a soft landing' but certain overbuilt/overpriced locales will probably feel some pain," Crawford said. "As we have pointed out in the past, the softer housing trend will eventually slow prepayments, which is good for Trust IOs." In his research, Crawford said that Trust IOs currently look cheap, particularly off 6s now that they are a discount. He added that hedging them with collateral creates a positive carry/negative convexity position.
Prepayment outlook
Preliminary information suggests that April speeds will slow around 5% to 10%. Factors influencing the report include a lower day count -19 days versus 23 days. Another factor is the modest decline in refinancing activity, averaging 1594 in March, compared to 1633 in February, due to the higher mortgage rates (6.32% average in March, up from a 6.25% average in February). Speeds are expected to pick back up in May given the higher day count. In general, discount coupons are expected to continue to prepay relatively fast over the spring and summer months, while higher coupons should remain steady.
In a recent report, Merrill Lynch analysts looked at agency hybrid prepayments. Analysts said that in the near-term, they expect hybrid prepayment volumes to drop for the April report primarily due to the four day dip in day count. The day count factor should reduce prepayment speeds by about 18%. Researchers said, however, that purchase activity continues to be strong and they noted that the nonseasonally adjusted monthly average purchase index rose 10% between February (412) and March (455). Refinancing activity, on the other hand, is still lagging, mainly because of higher prevailing rates. The 5/1 Freddie Mac survey rate increased to 6.35% at the end of March from 6.26% at the end of February. Given all these factors, analysts believe that the dollar volume of agency ARM prepayments will dip between 10% and 15% in April to about $5.7 billion.
A look at agency hybrids
With a growing number of agency hybrids approaching their reset dates, Merrill analysts also said that it could be interesting to find out the impact of resets on overall hybrid prepay volumes. As they have shown previously, agency hybrids generally prepay between 60% and 80% CPR at reset. Thus, analysts stated that rising reset volumes could probably result in a considerably higher dollar volume of hybrid prepayments. However, the total balance of agency hybrids due to reset in 2006 is relatively low. Analysts estimate that only about $12.9 billion agency hybrids are estimated to hit their first reset dates during the remaining months of 2006.
Also, even though reset speeds can reach as high as 80% CPR, this means only 12.5% of the balance being paid off in a single month. Empirical evidence demonstrates that among FNMA hybrids scheduled to reset each month, only between 8% and 12% of the scheduled reset balance was actually paid off in the month of reset, noted Merrill. For instance, researchers estimate that about $429 million FNMA hybrids were scheduled for their first reset last month, and approximately $44 million of the $429 million was actually paid off. This represents about 1% of the total dollar volume of FNMA hybrid prepayments in March, said analysts.
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