While some days in August lived up to its "dog days of summer" moniker, the stats suggested anything but. The month reported several stronger-than-expected key economic releases beginning with the July employment report that showed a loss of just 247,000 jobs compared with a projected loss of 320,000, with the unemployment rate slipping to 9.4% from 9.5%, and concluding with a better-than-expected Chicago PMI for August at 50 versus a consensus call of 48, and up from 43.4 in July.
The housing reports were also encouraging with July new home sales, jumping 9.6% with months' supply dropping to 7.5 months from 8.5 months in June, while July existing home sales rose 7.2% on a seasonally adjusted basis. Home sales were helped by historic affordability levels and the $8,000 first-time home buyer tax credit. Second-quarter home price data reported a slowing in home price declines. According to the Federal Housing Finance Agency's (FHFA) House Price Index, home prices declined 6.1% in the second quarter from a year ago compared to negative 7.1% in the first quarter, and Standard & Poor's/Case-Shiller recorded an annualized price decline of 14.9% in their National Home Price Index for the second quarter compared with negative 19.1% in first quarter.
On top of the many favorable economic reports, there was a full Department of the Treasury supply calendar with a total of $174 billion spread over 2s, 3s, 5s, 7s, 10s and 30s auctioned. Treasurys initially reacted negatively to the employment report with the 10-year note increasing to 3.854% at the close of Aug. 7 from 3.501% at the end of July. However, despite the further positive economic news and heavy supply, the 10-year note ended the month at 3.401%. Equities were also buoyed by the prospect of an improving economy and rallied 325 points over the month.
Mortgages, meanwhile, recorded a mixed response for the month. For August, Barclays Capital's MBS Index outperformed Treasurys by 19 basis points but lagged ABS (180 basis points), CMBS (174 basis points) and U.S. corporates (72 basis points). Spreads ended the month at about 79/10-year swaps and 99/10-year notes, wider respectively by 14 and 11 basis points from the end of July. Overall, MBS volume was modestly above average based on TradeWeb's experience versus slightly below in July.
Outside of the Fed, real and fast money were mixed along the coupon stack with a strong focus on 5s, 5.5s and 6s. Particularly seen as favorable for 5.5s and 6s was that they are away from supply issues and are at less risk for loan modifications. With yields lower, there was convexity-related buying during the month. Bid list activity picked up from banks and money managers, particularly in the latter half of the month, on profit taking ahead of month end. Some were also motivated to move into TBAs as a result of the specialness of dollar rolls in premium coupons. The lists were mostly met with good demand.
The Fed remained the largest supporter of the mortgage sector, averaging $5.0 billion per day and outstripping mortgage banker supply by about an average of two times. Of the Fed's purchases, 60% was in 5%s and 29% was in 5.5%s. Meanwhile, originator supply over the month was largely in 5% coupons and to a smaller extent in 4.5s and 5.5s. Through Aug. 27, the Fed has bought $792 billion in MBS with $458 billion left to go in their plan to purchase $1.25 trillion by the end of 2009. With 18 weeks to go before year end, this equates to $25 billion per week.
Since March, monthly gross issuance has averaged $178 billion per month; however, beginning in September, Bank of AmericaMerrill Lynch analysts believe average monthly issuance will drop to between $95 and $100 billion at current mortgage rate levels ranging in the 5% to 5.5% area. Between this projection of $380 to $400 billion in total gross supply over the next four months and the Fed's balance of $458 billion left in their 2009 MBS buy program, the supply/demand technicals look very favorable. This is a reason BofA/Merrill favor an overweight on agency MBS versus Treasurys.
The big question that has been making the rounds, however, is will the Fed buy the $1.25 trillion in MBS by the end of the year, or will purchases be adjusted. There was some uncertainty raised on this recently following comments from St. Louis Federal Reserve President James Bullard and Federal Reserve Bank of Richmond President Jeffrey Lacker. Bullard suggested that buying all of the $1.25 trillion might not be necessary, while Lacker said he intended to evaluate closely the need to purchase the full amount.
The Federal Open Market Committee (FOMC) minutes from the August meeting contained no decision on MBS purchases in terms of slowing the pace or extending the purchases into 2010. There was some discussion between the committee and a number of participants suggesting that a gradual slowing in the pace of MBS purchases could be helpful in the future as the program nears completion. However, the FOMC made no decisions on tapering those purchases during the meeting.
Street research has been discussing this issue lately. Specifically, JPMorgan Securities analysts said they think it makes sense for the Fed to slow purchases gradually - as it had appeared to be doing in July through early August - versus abruptly ending the program at the end of the year. This would give the Fed investment flexibility into 2010 if it were required.
Barclays Capital suggested that the slowing in purchases is likely related to the decrease in supply. They believe that in light of this, the Fed will reduce its pace of purchases.
"Thus, it seems reasonable that the MBS program may be extended to complete the $1.25 trillion in purchases or that it could be cut short of the full amount," Barclays analysts said.
Either of these options are negatives for the basis, analysts added. At the same time, they pointed out that with the government still working out a plan for the GSEs with an announcement expected in February 2010, slowing their pace of purchases "would allow the Fed to control spreads better in the event an announcement is viewed poorly by the market."
Citigroup Global Markets analysts also believe Fed purchases of agency MBS will be extended into 2010 with no increase. They partly believe it will be difficult with reduced origination for the Fed to purchase the total $1.25 trillion by the end of the year. While spread volatility should increase as a result of various opinions regarding the end of the Fed's program, analysts don't expect spreads to move meaningfully wider. Citi analysts also said in the report that any official decision is not expected for a couple of months.
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