With the possibility of a slow rise in interest rates going forward, MBS analysts are starting to ask what impact this event would have on mortgage-backeds.
"When rates rise, it will more likely be gradual rather than aggressive, which should avoid putting widening pressure on swap spreads because of portfolio rebalancing activity by mortgage servicers and the GSEs," said Kevin Jackson, senior analyst at RBC Dain Rauscher.
He stated that MBS should outperform in this particular scenario considering that technicals should remain strong. Yield curve flattening will decrease the rate by which CMOs are made and prepayment fundamentals will likely improve. Dollar roll financing could also soften, but the agency bid will keep MBS flows limited. He added that, when this situation occurs, the extension trade will be king.
What of curve flattening?
Though the curve has flattened considerably since the Fed eased, further flattening going forward should be more moderate, experts said. Furthermore, analysts stated that the impact of a flatter yield curve will not be as extreme in the current environment.
"A flatter yield curve is negative for mortgages in general as it increases the long-term callability of mortgages," said Yubo Wang, a mortgage strategist at Morgan Stanley. "However, its impact could be mild in the current environment as there are offsetting factors."
The first is that the yield curve is still steep when compared to the long-run and recent experience, something that should continue to support carry. The second factor is that a flatter curve could cause more harm when mortgage rates are high than when they are low. Mortgage rates, said Wang, remain near historical lows, and the vast majority of outstanding mortgages remain refinanceable.
"Incremental risks from curve flattening can be limited barring a massive market repricing," stated Wang.
The last reason why a flatter curve is less harmful in the current environment is that it could offer some extension protection should rates rise from here. Wang added that in a curve flattening environment, the strategy to move down in coupon and investing in current coupon should be an advantage given that lower coupons have longer duration and reduced prepayments risks.
