The first Federal Reserve hike will probably trigger the unwinding of the MBS carry, an event that could lead to a major bear market-induced steepening, said Ifty Islam, head of U.S. fixed income strategy at Deutsche Bank. These remarks were made at a media briefing held last week.

The duration of mortgages is more sensitive to moves in interest rates compared to Treasurys, making the sector much more difficult to hedge.

In an earlier publication, mortgage-backed analysts from Deutsche said that money managers and banks had used the carry trade by buying lower-coupon 30-year MBS and financing them through the end of 2002 and the first half of last year. Unfortunately, this trade unwound in a "dramatic fashion" in no time.

"As this mortgage duration extension-related selling was initiated by Fed-misspeak on the long end, one is left to wonder if a similar fate to MBS performance could happen in 2004 with a hike on the short end," wrote analysts.

However, they also pointed out that the mortgage market is already over the point of maximum negative convexity, rendering duration extension less of a risk in the mortgage universe than it was in mid-2003. But they reiterated that a Fed hike could still trigger an unwinding of the MBS carry trade, which is expected to cause significantly more damage to MBS than the convexity-hedging trade.

Deutsche also noted that Fed-induced tightening usually compels investors to move into higher coupons. A 25 basis point rise above the forward scenario pushes buysiders toward 30-year 6.5s and the lower-coupon 15-year collateral, over similar 30-year product. Investors who are worried about the carry trade ending in 2004 should look into these trades, analysts

suggested.

In his discussion, Deutsche's Islam also mentioned that bank liquidation of mortgages happened simultaneously with convexity hedging pressure last year. While banks were liquidating some of their mortgage holdings, the GSEs and other mortgage servicers were, at the same time, trying to hedge convexity risk. Islam referred to June 2003 when banks pass-through holdings peaked, and then dropped rather precipitously in the next two to three months.

Economic outlook

In terms of the economy, Peter Hooper, Deutsche's chief economist, stated that the U.S. has shown above-trend growth resulting from monetary and fiscal stimulus as well as a declining dollar. He said that economic growth would be in the 5% vicinity through 2004, slowing to around 3.5% to 4% vicinity next year.

"Overall, prospects for above-trend growth look good, with risks more balanced than previously, but still slightly to the downside," said Hooper.

The growth will also be driven by a moderate expansion in consumer spending, which will be supported by a decent increase in consumer income and the consumer's willingness to save less.

On the other hand, business spending has a long way to go in terms of both capital spending and hiring. However, Hooper said that hiring would pick up as the rise in productivity slows. Further, the labor market is showing signs of improvement as the unemployment rate has declined to roughly 5.5%. It is expected to move closer to 5% in the later part of 2004 and dip further to a little below 5% by next year.

Real interest rates are expected to head significantly higher, with private institutions and the government having fewer savings at their disposal. Rising business investment is also a factor. However, an economy that is growing at above trend could readily digest the rise in rates, although there are admittedly some risks involved, said Hooper.

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