Checking on the Status of the MBS Market Without the Fed: Stage 1 Complete

If you missed the post which discussed yield spreads and the secondary market current coupon: HERE IT IS. Reading and understanding this content will undoubtedly help mortgage rate watchers better understand the underlying causality of movements in mortgage rates. 

Reminder: the secondary market current coupon is essentially the MBS yield  lenders use to derive par mortgage rates after servicing and guarantee fees are stripped out

For example, have recently higher mortgage rates been a function of a localized lack of demand in the secondary mortgage market (MBS) or a factor of generalized weakness in our benchmark guidance givers??? (Treasuries and Swaps)

If mortgage rates were led higher by a lack of demand (or supply/demand disequilibrium) specific to "rate sheet influential" MBS coupons...weakness would show up via wider secondary market current coupon yield spreads. Let's take a look at the scorecard...

The day of the Fed's exit from the Agency MBS Purchase Program, the current coupon yield spread was:

Yield Spread Calculation: 4.467% - 3.841% = 62.6 basis points

The day after the Fed's MBS funding ran dry, the current coupon yield spread was:

Yield Spread Calculation: 4.613% - 3.919% = 69.4 basis points

Yield spreads widened and MBS valuations cheapened as mortgage market participants employed a "sell now ask questions later" strategy to MBS positions..which pushed mortgage rates higher.  This is how we thought the  how the initial knee jerk reaction might play out.  View this as stage 1 of the Post-Fed "feeling out" process.

Plain and Simple: Secondary market current coupon yield spreads were noticeably wider the day after the MBS Purchase Program ended as accounts of all types were seen selling "rate sheet influential" MBS coupons. While benchmark Treasury yields did indeed move higher, which did not help our cause in anyway, localized weakness in "rate sheet influential" on the day after the Fed exited the MBS market played a big role in rising mortgage rates.

WHAT HAS HAPPENED SINCE THEN?

New loan supply from mortgage originators has been well-below average and loan servicers haven't been forced to sell their "rate sheet influential" MBS holdings (duration shedding). This presented a bargain buying opportunity for traders. "Buying at the wides" (yield spread wides) was seen and yield spread widening reversed course. Now relative valuations (yield spreads) sit close to where they were when the Fed was still buying mortgages.

Currently, with the Fed's "official bid" absent from the agency MBS market, the current coupon yield spread is:

Yield Spread Calculation: 4.603% - 3.956% = 64.7 basis points

Plain and Simple: The Fed's exit is far from forgotten, but the initial knee jerk reaction "feeling out" process appears to be behind us. "Rate sheet influential" MBS coupon yield spreads are still relatively rich (tight)!!!

WHY HAVEN'T MORTGAGE RATES CORRECTED THEN?

To be as economical with my words as possible...our benchmark guidance giver has not allowed it.

Remember there is such a thing as yield spreads being too "rich" (too tight). If benchmark TSY yields rise and MBS yields do not, then yield spreads tighten. If yield spreads get too tight, traders will sell their MBS holdings (take profits to find better returns in another fixed income asset). So while private demand in the MBS market has been sufficient enough to offset minimal "rate sheet influential" supply, which has kept MBS yield spreads tight and helped avoid further increases in mortgage rates, MBS prices have been forced to adjust just to keep yield spreads from getting too "rich". 

Plain and Simple: If TSYs sell, mortgages will generally play "follow the leader". READ MORE ABOUT THE MORTGAGE RATES EQUATION

Recently higher mortgage rates have not been a function of the Fed's exit from the MBS market as much as they have been a factor of rising benchmark Treasury yields! The 10 year note rose over 15 basis points in the day's following the end of the MBS Purchase Program!

My point:  Stage 1 of the Fed's exit looks to be behind us with only minimal damage done. Rising mortgage rates have been more a function of higher benchmark yields vs. localized weakness in the agency MBS market. This "follow the leader" relationship might not be so tightly correlated in Stage 2 of the "feeling out" process though, especially if home buyer demand gains traction and new MBS supply picks up (mortgage originators have until late June to lock these borrowers). If Treasuries can mount some recovery momentum of their own...mortgage rates should fall a few basis points. There is a negative attached to this theory though. Rising mortgage rates have served to slow down new MBS production, which has helped keep rates from moving higher (lower mortgage rates = more MBS supply= wider yield spreads) . Falling mortgage rates should have the opposite effect. If/when TSY yields rally and mortgage rates are able to "play follow the leader"... many folks will be quick to lock in their loans. This implies we should be expecting more MBS supply when rates fall and therefore wider secondary market current coupon yield spreads (more than they already would when pacing a TSY rally).If TSY improvements can hold...we should then see "buying at the wides" and a return to status-quo yield spread levels. This would be the end of Stage 2.

With MBS yield spread valuations holding steady near Fed support levels, we turn to benchmark Treasuries for further guidance. We need 10s to break back into the 3.57 to 3.85% range!