Supportive flows during the first part of last week helped mortgages recover from a negative start in February. According to Lehman Brothers, the month-to-date excess return versus Treasurys for the MBS Index was a positive three basis points as of Feb. 8.
One major contributing factor to mortgage performance was the lack of supply, which averaged less than $1 billion per day. There was also real and fast money taking advantage of the early month weakness on Feb. 6, while the following day brought additional buying interest from January paydowns that totaled $33 billion. While Asian investors were back from their week-long holiday, their participation was rather disappointing and was attributed to expectations of better yield opportunities following the refunding.
Servicer selling quietly picked up over the week as yields rose, particularly in FNMA 5s. On Feb. 8, MBS selling apparently totaled around $3 billion, largely from servicers, but also from hedge funds. Some participants expressed concern regarding the bearishness creeping into the market as the 10-year yield approaches 4.65% on risks that increased servicer selling would more than offset any buying.
However, Alec Crawford, a managing director and head of agency MBS strategy at RBS Greenwich Capital, suggests that, "normally, a move higher to a 4.65% UST 10-year would cause servicers to start shedding duration, but the further inversion of the yield curve is having the opposite effect, and softening the blow of higher rates/duration extension."
Near-term MBS outlook
The near-term mortgage outlook suggests increasing risks based on analysts' comments. Of concern are the tight valuations, curve inversion and potential servicer selling. Technicals, however, remain very favorable for the sector with originator selling at average to below average levels.
JPMorgan Securities analysts say the strong demand in mortgages has been motivated by expectations of further declines in volatility as the curve inverts. Analysts from the firm believe volatility declines are fully priced in and that the more relevant factors for the mortgage market are spread widening and collapsing carry.
Crawford added that banks and other funded investors will like MBS less as a result of the curve inversion. Countrywide Securities researchers add that there appears to be limited upside to re-establishing the trading range.
Bear Stearns analysts say mortgages seem to be a "reasonable buy" as they do have carry against swaps, at least. They expect that if rates remain within a modest range, income will dominate portfolio returns and MBS will keep attracting buyers. Analysts caution that one near-term risk is this week's semiannual testimony before Congress by the new Federal Reserve head Ben Bernanke on Wednesday and Thursday. Any suggestion that there might be a few more interest rate increases could cause mortgages to widen as the market reacts to such news.
Market volatility
UBS analysts held with their modest overweight. They note mortgages are fair value on their model largely because volatility is very low compared to historical standards. They believe volatility should be low due to the flat curve and lack of refinanceability in the mortgage market.
In their most recent report, analysts compared the U.S. swap market to other global swap markets. UBS analysts concluded that volatility is significantly higher in the U.S. market, which is a reflection of the presence of the mortgage market. They added that, as rates continue to rise, the amount of negative convexity in the U.S. market will be lessened and volatility will come closer to that of other international markets. They also argued that U.S. volatility is higher than it is supposed to be compared to the euro zone and the U.K., leaving room for a further decline in U.S. volatility.
"We do not expect volatility to drop dramatically with rates unchanged," analysts said.
However, they added that the issues discussed in the report they put out, "argue strongly against selling mortgages because of fears of a rise in volatility."
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