The firm recommends selling 30-year 5.5s and buying a duration-weighted amount of 5.0s. The rally in bonds has quickly pushed 30-year 5.5s to a point where prepayments are expected to rise substantially in the months ahead; this will serve to limit further price upside on 5.5s. 5.0s should also benefit from a flatter yield curve, as investors typically react to curve flattening by buying the lowest available 30-year coupon. In addition, we expect 5.0s to benefit from enhanced liquidity, as issuance and CMO activity in the coupon increase over time, laying the foundation for persistent specials in the TBA roll market.
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