After the recent really wacky rally resulting from disappointing employment figures, analysts last week, once again, warned about refinancing and convexity triggers being hit.

As of last Wednesday, JPMorgan Securities turned neutral on the issue, and said "the market appears to be setting up for a mini whipsaw, making MBS hedging a dicey proposition."

Analysts noted that the market has rallied to a point where mortgage money managers have not caught up enough to adjust their hedge ratios.

In a report released the same day, JPMorgan said that for every 10 basis point rally, analysts expect a quarter of a year of MBS Index shortening. Also, banks might back out temporarily as yields approach six-month lows, which JPMorgan considers a near-term negative for the MBS market. Meanwhile, the GSEs will probably remain out of the market for another five to six basis points of widening, analysts said.

The firm also mentioned a strong up-in-coupon bias as well as dealer support for IOs. The appetite for IOs, analysts said, seems misplaced since IOs would potentially be vulnerable to a whipsaw.

Analysts said IO trades, in particular, are under-hedged. For instance, 30-year 5s have hedge ratios that are about 2.8X or 2.9X those securities, which would be sufficient if rates continue to rally. However, if rates back up, investors would effectively own the IO at a much higher dollar price.

What's next?

In last week's Mortgage Strategist, UBS addressed the following questions: (1) How far is the market from previous lows in mortgage rates? (2) What is the impact on production if rates rally modestly from current levels? (3) Are mortgages likely to cheapen in a rally?

UBS calculates that primary mortgage rates at present are 50 to 55 basis points higher than June's lows, which is the lowest that primary mortgage rates have been since that period. In October, the average no-points rate was only seven basis points higher than currently and, at that time, the Refi Index reached 3000, analysts noted. They expect the current level of rates to have a more muted impact this time around with the Refi Index only expected to range between 2400 and 2800.

The composition of the mortgage market has changed since last June. If rates move back to those levels, a smaller portion of the market would be marginally refinanceable - 85% versus 99%. Currently, UBS calculated 48% of the market is marginally refinanceable while 41% is fully refinanceable. If mortgage rates drop about 24 basis points to a no-points rate of 5.61%, 6% coupons would be fully refinanceable, thus making 75% of the market marginally refinanceable.

Analysts said that the recent rally has not caused a significant rise in mortgage production. But at these levels, banks should be buying less. There has even been a fair amount of selling, with the assumption that a better time to buy mortgages lies ahead.

UBS expects supply to be in the $75 billion per month range. If rates decline 20 basis points, analysts project supply to increase to $93 billion while a 40 basis point drop will result in a supply of about $123 billion. Last August, the supply peaked at $186 billion.

If the market sells off from these levels, mortgage bankers will likely partake in limited selling, UBS said. However, without the banks absorbing this, mortgages potentially can become cheaper temporarily. But if there is a further selloff, banks should return to the fold. Meanwhile, if the market rallies, mortgages should become cheaper. A 20 basis point rise in rates would increase production by more than 25%.

It's not as bad this time

Art Frank, head of mortgage research at Nomura Securities International, said that mortgages could widen by about five to seven basis points if the 10-year Treasury rallies to 3.8% from its current level of 4.0% (as of last Wednesday). This spread widening would put it at the level seen in last month when current coupon 30-year MBS traded at 108 basis points over the 10-year. As of last Wednesday, trading levels were at 101 basis points over the 10-year Treasury. On the other hand, a 20-basis point back-up in rates could cause a tightening to about 95 basis points over the 10-year.

As for mortgage market supply, even a 30 basis point rally from current levels is unlikely to bring the same deluge of supply as last summer. This is because the weighted average coupon of the mortgage market is down sharply from eight months ago. Frank said that the peak of the refinancing wave has already occurred, so therefore fewer mortgages are refinanceable.

"We would expect a much milder reaction to lower rates than we saw last summer," added Frank. However, the number of those potentially refinancing could still be considered substantial.

He added that even if the Refi Index would get to less than half the level it was last May and June, actual refinancing on premium pools would be much higher than half last spring's level. Over the past year, the weighted average coupon of outstanding Fannie Mae and Freddie Mac has come down about 70 basis points, so the market is a lot less refinanceable at the same rates as it was a year ago.

What does latest rally mean for speeds?

Lehman Brothers expects TBA 6s to prepay in the high 40s and possibly into the 50s. With this rally, JPMorgan said 2003 and 2002 premiums should show a muted slowdown in January. This is supported by UBS, which is forecasting 2002 FNMA 5.5s to prepay at 17% CPR versus 17.7% in December; 2002 6s to slow to 30% from 32%; and 6.5s to decline 3% CPR to 40%. Looking ahead to February's prepayment report, JPMorgan expects speeds to hold flat or slightly increase. Last month, analysts were anticipating speeds to slow in both January and February before picking back up in March.

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