Revisiting the "Phantom Coupon" Discussion. Will We See 3.5s Trade Forward In Size?

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Even though rate sheet influential MBS coupons backed away from newly set record (again) price levels as risk markets rallied today, rate sheets were 7.4bps better on average and buydowns cheapened 2.1bps, on average.  Yesterday we witnessed two lenders adjusting their hedge ratios via a wider spread between best efforts and mandatory offers. THIS IS WHY. Today that spread tightened 10bps which means the major lenders have less margin baked into their rate sheets than they did yesterday.

We are starting to see a slow migration toward a 4.375% "best execution" note rate, the next stop after that is the 3.50 MBS coupon and 4.25% par rates. 3.50s are currently bid at 99-20 in August and 99-04 in September. 3.50 coupons account for less than 2% of daily trading flows, so that market still isn't liquid. 

WHY HAS THE 4.375% TO 4.25% THRESHOLD BEEN SO HARD TO BREAK? 

It's a factor of how mortgage notes are delivered into MBS coupons. The lowest note rate that can be used to fulfill a 4.0 trade: 4.25%, and generally lenders cut off 4.0 forwards at 4.375% note rates because it's not economically efficient to trade 4.25s into a 4.00 coupon. If the lender wants to sell forward a 4.125% note rate in the TBA MBS market, they'd have to trade it as a 3.50 MBS coupon. Well,  because there was never liquidity in the 3.5 MBS market,  at least not for anyone looking to sell forward their pipeline "IN SIZE", mortgage rates never made a solid attempt at 4.00%.  Read liquidity as: A seller being able to find a willing buyer without having their offer price hit badly because there were no other willing buyers of size (buyer's market).

Right now the 3.50 MBS market is still considered "phantom" because there aren't enough "buy and hold" duration buyers out there who are willing to take on the added extension risk, plus there are cheaper hedges, so the lowest rate lenders are offering consumers is: 4.25%

Besides all out depression, I'm not sure what would drive the TBA MBS market to trade 3.50 MBS. My best guess: 10s need to trade down below 2.85% (more like 2.65%) and hold at or below that level before we see 3.5s trade to shorter hedge ratios. Even then I find it hard to believe dealers would be willing to take on that much extension risk without tagging sellers with a hefty price discount. We're already having delivery issues with 4.0s, 3.50s won't be much better (capacity issues).

Here is another perspective. Remember, when the Fed was buying mortgages last year and 10s were yielding 2.50%? Even then only $242 million 3.5s were bought by the NY Fed's desk. That's 0.02% of the $1.25 trillion large scale asset purchase program. Not a refreshing stat, then again lenders are battling it out to keep their pipeline full, so you never know in this environment. Especially with the depression card still on the table.

Either way, agency MBS are in high demand and mortgage rates are hovering around record lows. Best of luck getting qualified borrowers (and collateral) to the table.....if we are to see 3.50s trade, we gotta fill 4.0 buckets to ensure new production is delivered on time. We don't want fails in the production side of the stack, although the short squeeze wouldn't hurt in the short run.