The mortgage sector is currently adding duration at the fastest pace in two years, according to a report by JPMorgan Securities released recently.
The growth in 30-year mortgage product is now higher versus 2003, when net production was comprised mostly of 15-year collateral. Analysts added that, unlike 2003, the current duration supply would probably prevail beyond October, since it is not the result of a refinance wave but rather a shift to fixed-rates.
The question that analysts posed was: Can a sharp rise in fixed-rate originations cause a bear steepener?
Although it is well known, analysts noted, that rate movements can be exaggerated by convexity hedging demands, there has been somewhat less focus on the curve impact. Unlike convexity hedging exacerbating rate changes, analysts said that mortgage supply tends to counteract extreme curve changes, although with a considerable lag. For instance, in a steep curve scenario like 2003 and early 2004, mortgage borrowing shifts to the front-end with more 15-year and shorter reset hybrids, resulting in 2004's negative 30-year net supply and limited mortgage duration. By contrast, with the continued curve flattening in the first half of 2005, production has slowly shifted to 30-year fixed-rate paper. JPMorgan analysts said the shift to 30-year fixed supply has a greater market impact than the shift to ARMs because fixed-rate loans have a higher securitization rate.
JPMorgan analysts added that a bear steepening could quickly gain momentum as mortgage extension is made worse by combining higher rates and a steeper curve. For instance, in the Fall of 2003, the Treasury curve steepened by more than 50 basis points 2s to 10s. Every 20 basis points steepening corresponded to almost 0.2 years of extension, equal to adding $75 billion in 10-year equivalents.
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