Though a Fed rate cut is generally good for MBS because it leads to a steeper yield curve, last Wednesday's less-than-expected 25-basis-point ease - some market participants were anticipating a 50-basis-point cut - caused the curve to flatten, resulting in a relatively poor environment for mortgage-backeds later in the week.

"You saw a significant flattening, especially in fives and 10s," said David Montano, director of MBS research at Credit Suisse First Boston.

He added that even though spreads did not move much last Wednesday, agency debt did very well. Five and 10-year Agencies outperformed swaps, causing mortgages to significantly lag Agencies. However, since spreads did not widen, MBS performance versus Treasurys was not quite as bad.

Spread directionality

A medium-term concern, however, is the direction of spreads in the market considering a recent decline in corporate issuance. A swoon in corporate paper may drive spreads tighter, because corporates are frequently swapped to floating-rate. Moreover, the high level of mortgage issuance of net and refinancing originations is adding spread duration to the market. Therefore, the reaction to the most recent Fed rate cut may be different than the reaction to the Fed cut that surprised the market in January.

"We do not believe that we will be seeing the mortgage-related convexity buying that we saw earlier this year," Montano said. "However, spreads do have the potential for widening. I don't think they will be tightening very much in the rally. In general, I don't think we will be seeing a whole lot of directionality in spreads - it's more like a big gap move."

Montano is bullish about the 15-year sector, however. Though bank sponsorship has not been in that sector recently, this may change soon. With a flatter curve, the yield differential between 30s and 15s diminishes. Therefore, if a bank is funding in the front-end of the curve - the two-year or shorter range - it would care more about twos and fives than fives and 10s. If fives and 10s remain flat and twos and fives are still steep, then 15s would look attractive, Montano said.

MBS: relative value and the refi wave

According to Art Frank, head of MBS research at Nomura Securities, last week's major curve flattening had varied effects from a relative-value standpoint: compared to the 10-year Treasury mortgages widened significantly, while compared to the five-year treasury they did relatively well.

"The 10-year Treasury has sold off much less than the short-end of the curve and we've had a rather dramatic reshaping," Frank noted.

He said that if one compares Tuesday's close to Thurday's close, the two-year yield was up 21 basis points, from 4.00 to 4.21, and the ten-year was only up 10 basis points from 5.22 to 5.32.

"So we've had a 11 basis point flattening. As a result, mortgages cannot keep up with the 10-year; they have fallen significantly against the 10-year," he said.

However, the higher mortgage rates will likely curb the refi wave.

"Because 6.5s actually finished down below 99, fears that the refi wave would re-ignite have eased a lot," said Frank. "At these price level, the refi wave is likely to peter out."

Things may turn around

Though it does not presently look good for MBS, some market players remain optimistic that in the long run things are going to turn for the better.

"In the short term it's not a good scene for mortgages," said Kathy Foody-Malus, vice president and senior portfolio manager at Federated Investors. "That is mainly because of the fact that the investment community is having to readjust its expectations from a very aggressive Fed to a Fed that is being more methodical and plodding, and obviously you are dealing with a significantly flatter yield curve so it's not the best environment."

However, Foody-Malus said that if market participants look beyond the short term and think in terms of the longer haul, then mortgages would make sense.

"I like mortgages from a longer term perspective because I still make the argument that it is a very attractive spread asset class," she said. "I believe that we are going to be in this trading range within the Treasury market for awhile just because of the fact that we are in a state of limbo with regards to the economy and where we are headed."

Last Wednesday's Fed cut is the fifth so far this year. This most recent Fed ease has brought the decline in the target federal funds rate since the beginning of the year to 275 basis points.

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