MBS CLOSE: Exploring Rates Strategy Heading into Year End

So I have to be honest...I was unaware of the Dubai debt story until this morning.  At 7:33pm on Wednesday November 25, this flashed across my news feed:

I could have cared less about my news feed at 7:33pm on the evening before Thanksgiving. I had no position to manage because I was watching and waiting for a better signal from the market before regrouping and re-evaluating directionality...plus, it was the night before Thanksgiving!

The fact that the event hit news wires at a time when so  many were disconnected from the market, or just "could have  cared less", does make me wonder if someone is trying to be sneaky, maybe hiding something? Then again, who can blame Dubai for picking such an opportune time to alert the masses of a pending "credit event" .

H.H Sheikh Ahmed bin Saeed Al-Maktoum, Chairman of the Supreme Fiscal Committee and life vice-president of Chelsea Football Club downplayed the announcement:

"Like most global cities, Dubai has experienced its share of economic and social challenges in this global downturn. No market is immune from economic issues. This is a sensible business decision."

"Our intervention in Dubai World was carefully planned and reflects its specific financial position. The Government is spearheading the restructuring of this commercial operation in the full knowledge of how the markets would react. We understand the concerns of the market and the creditors in particular. However we have had to intervene because of the need to take decisive action to address its particular debt burden.

Does it really matter? Why are we still talking about this?

It could matter I guess...if there's some long run implication that I'm failing to notice/speculate on...which leads me to internally re-consider the previously mentioned "sneaky" theory.

We are still talking about this because the "event" pushed long term TSY yields through a FIRM level of resistance....RIGHT AFTER THE MARKET JUST BROKE THROUGH A FIRMER RESISTANCE LEVEL AT 3.32%.

If I was being asked whether or not I would chase the recent rates rally...I would have to say that I wouldn't do so until booking  profits (which was seen today) and waiting for volume to accumulate into a confirmation/rebound rally. The Dubai event is not confirmation of Tuesday's breakout to 3.27% btw...so, if profits are taken in size, we might actually re-test 3.32% again.

If the above does occur, it will be interesting to see how the market reacts.

Will window dressing strategies support a bid in "rate sheet influential" TSYs? Will year end profit churning remain focused on a earning a few extra bps in the long end of the yield curve? I don't see why not...the marginal risk one takes on for the extra return is well worth it.

While banks have been more or less unwilling to lend to consumers and small businesses, they have not been so shy with the US Government.  Borrowing short and lending long (FICC) has boosted P&Ls..consistently, in financial year 2009. We dont expect it to stop now. But you know what that means...part of the "window dressing" process is taking profits. This implies more range bound behavior, two steps forward, two steps back, two steps forward one step back, etc, etc.

I repeat what I wrote on Tuesday afternoon, before the Dubai "credit event".

The range consistently moderated directionality over the summer, into fall, and continues to do so heading into winter..while trips outside the range have occurred, they have not lasted long. We must continue to base our bias on the price levels accepted by the marketplace. That said, while we are thankful for rapid appreciations in the rates market, we are not comfortable with the speed and style in which they occurred.

Play the range until the range plays you (and proves it). This strategy has proven profitable for originators managing their personal pipeline in the second half of 09.

What does this mean for mortgage rates?

The focus on year end/profit churning/window dressing has been supportive for MBS recently. Over the past three week's, yield spreads have tightened as MBS demand has outnumbered supply at a 3:1 ratio. While somewhat hesitant to chase the MBS rally, even banks have put cash to work in richly valued MBS.

Whether or not mortgage rates hold steady (as opposed to rising), near record lows, depends on whether or not MBS "bargain buyers" step in to take advantage of cheaper valuations...aka "buying on the dips". This has occurred consistently over the past three weeks, again I see no reason to believe this does not continue into year end (or at least until Class A settlement on Dec.10). However, just as TSY profits must be booked, so to must MBS profits..implying that, just as TSY are range bound, so too are "rate sheet influential" MBS.

"Rate sheet influential" MBS currently at the upper limits of that range, venturing into unexplored territory...

If benchmark TSY rates do continue to fall and the secondary  market current coupon does continue to migrate into the 3- handle... it does not mean mortgage rates will be venturing deeper into record breaking territory.

Lenders will find it more expensive to offload loan paper originated below 4.50%. The volatile duration of 4.0 MBS coupons adds an extra helping of "extension risk" to the value of mortgage related cash flows. While the Fed is still participating in the agency MBS market, they too should be looking to avoid adding more duration to their portfolio, especially with the TSY extending the maturity of their debt to line up with the duration of the Fed's MBS portfolio. (Incoming cash flows offset outgoing cash flows).  That said, we don't expect the Fed to be heavy buyers of 4.0 MBS. If TSYs do manage to rally on, we would anticipate a widening between primary mortgage rates and the secondary market current coupon yield. (hmmm...excess servicing income!)

So, with all those considerations in mind, I am sticking to my lock bias. Rebate is too aggressive.

The market is now closed.

The FN 4.0 ended the shortened session +0-13 at 100-10 yielding 3.977% and the FN 4.5 went out +0-06 at 102-16 yielding 4.195%. The secondary market current coupon ended the day below 4.00%...at 3.977%. I did not increase my prepay speeds on the 4.0 and I am not using the 3.5 in my current coupon calculation.

The CC is +77/10yr TSY and +67/10yr swap. MBS Current Coupon yields are wider to benchmark yields..this is a normal occurrence when TSYs benefit from a flight to safety rally, especially when MBS trade flows are 25% of the 30 day average. Very thin day in MBS trading.

Here is the intraday FN 4.5...

On Monday we get the November Chicago Purchase Manager's Index at 9:45 am. Then motor vehicle says in the lunch hour.