In a report released this morning, UBS urged buysiders increase their overweight to mortgages from a slight overweight to a full overweight. Analysts said that they might even increase their position to a maximum overweight.

There are two major reasons for this shift, analysts said. The first is the strong employment number last Friday as well as the market backup that followed, which eased supply pressures. Analysts predict agency fixed-rate production of about $75 billion per month at these rate levels, which can be easily absorbed by the banks. At the pre-employment rate levels, the market was close to another refinancing wave. At this juncture, this is no longer a threat, UBS said. Aside from this, they expect that with the sell-off, bank purchases will increase significantly. Banks have a lot of cash that they were waiting for this backup to reinvest.

The second reason is that current coupon mortgages actually cheapened marginally on the firm’s models on Friday, as borrowers locked in and originators hedged their pipelines. Mortgages are currently cheaper compared to where they were for most of the November to February period, when the market was at these rate levels. Analysts think this cheapening is very temporary and will correct.

With the cheapening in current coupon mortgages, as well as the favorable carry the sector offers, UBS believes this is a good time for investors to put on basis trades. This is based on the possibility of the mortgage basis tightening. Lower coupon mortgages have done much worse than their higher coupon counterparts. The 4.5% coupon is clearly the cheapest in the stack, and it could get even cheaper, UBS states. Analysts suggest investors buy FNMA 5s and 5.5s on a duration weighted basis versus the 10-year Treasury note or against 10-year swaps. UBS prefers selling Treasuries than swaps. They also recommend a hedge ratio of 0.65 on the conventional 5.0% coupon and 0.51 on the conventional 5.5 coupon.

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