MBS RECAP: Out Just Below New 2011 Highs

After rallying swiftly on the heels of a successful 10yr note auction, production MBS coupons and benchmark Treasuries have pulled back slightly from their best levels of the year. Fannie Mae 4.0s are now only +10/32nds on the day at 101-15 after reaching 101-20 following the release of the Beige Book at 2pm. Unfortunately, shortly after setting new year to date yield lows, our directional guidance giver, the 10yr Treasury note, was seen running into an important resistance level, which drew out profit takers. While it's true MBS fell quickly from their highs as profits were booked in benchmarks, mortgages are still deep in positive territory. Bottom line, today's rally is intact in the after-hours session (3pm-5pm), and there is no material cause for concern. Profit taking is normal behavior.

Anecdotal reports from the twelve Federal Reserve Districts indicated that economic activity generally continued to expand since the last report, though a few Districts indicated some deceleration. Manufacturing activity continued to expand in most parts of the country, though a number of Districts noted some slowing in the pace of growth. Activity in the non-financial service sectors expanded at a steady pace, led by industries related to information technology and business and professional services. Consumer spending was mixed, with most Districts indicating steady to modestly increasing activity. Elevated food and energy prices, as well as unfavorable weather in some parts of the country, were said to be weighing on consumers' propensity to spend. Widespread supply disruptions--primarily related to the disaster in Japan--were reported to have substantially reduced the flow of new automobiles into dealers' inventories, which in turn held down sales in some Districts. Widespread shortages of used cars were also reported to be driving up prices. Residential construction and real estate continued to show widespread weakness, except in the rental segment, where market conditions have strengthened and construction activity and development have picked up. Labor market conditions continued to improve gradually across most of the nation, with a number of Districts noting a short supply of workers with specialized technical skills. Wage growth generally remained modest, though there were scattered reports of steeper increases for highly skilled workers in certain occupations. Most Districts continued to report widespread increases in commodity prices; manufacturers are said to be passing along a portion of the higher costs in the form of price hikes and fuel surcharges. Remember, the Beige Book summarizes comments received from businesses and other contacts outside the Federal Reserve and is not a commentary on the views of Federal Reserve officials.

Production MBS coupons have risen to new YTD price highs and benchmark Treasuries have fallen to new YTD yield lows following a successful 10yr note auction. The Fannie Mae 30-year 4.0 MBS coupon is currently +13/32 at 101-17. This level is only 4/32 better than the indications taken down by lock desks when loan pricing was built this morning, making positive reprices a possibility but more likely to occur if the intraday rally extends up to 101-20 and holds. At 2pm the Federal Reserve will release the "Beige Book", a summary of economic anecdotes from the Fed's business contacts around the country. This release carries the potential to confirm and even add to the intraday rally. REPRICES FOR THE BETTER territory is just ahead. Stay tuned. We will alert again if reprices are reported.

Treasury just auctioned $21 billion 10-year notes. The results were very average. The bid to cover ratio was 3.23 bids submitted for every 1 accepted by Treasury. Compare that to a 3.20 five auction average. The high-yield came in "on the screws" vs. the 1pm "When Issued" yield, indicating no price concession was priced-in during the auction itself. Dealers were awarded 41% of the competitive bid vs. their 41% five auction average. Directs added 8.35% of the competitive bid, which is actually 2.5% above their five auction average but close to their ten auction average. And indirects took home 50.6% of the issue, which is almost 3% below their five-auction average but close to their ten auction average. Average results may be discouraging but the fact that we're getting average demand after prices rallied significantly higher before this fundraiser tells us the market is very serious about the potential for a sustained interest rate rally as we head into the summer months.

Treasury is set to sell $21billion 10-year notes at 1pm. Out of three debt auctions this week, this issue carries the most influence over mortgage rates. There are two looming threats in the hours ahead that could lead to reprices for the worse. The first is a recovery rally in stocks. The second is a poorly received Treasury auction. Because rates have rallied significantly since the last auction and bond prices are much more expensive, traders could take aggressive action to cheapen up the issue before they buy it (concession).. If that turns out to be the case and buyers keep their wallets parked in their back pocket, it could force lenders to reprice for the worse. We anticipate strong demand to be displayed by investors though. And we think short covering will lead the way. This outlook is based on the large number of traders who are currently "short" the 10yr note. "Short covering" is when a bearish trader closes a position that was opened with the intention of capitalizing on lower prices/higher yields. The term "short" describes the trader's directional bias. "Covering" simply means closing the position. If a trader has set a short position and prices continue to rise, as they have recently, their position is considered to be underwater. Leaving a short position open as rates continue to rally can be dangerous because the position gets more expensive with every uptick in price. When prices fall and shorts are covered into lower levels, it means investors are waving the white flag on their bearish positions. That is what we expect to happen today. This theory is speculative in nature though. While we still feel floating intermediate to long-term deals is warranted, those working on a short-term timeline should keep a close watch on their rebate levels. Don’t lose new, lower "Best Ex" mortgage rate quotes. Five Auction Averages...Bid to Cover Ratio: 3.20. High-Yield vs. When Issued: -1.1bps. Dealer Award: 40.7%. Direct Award: 5.8%. Indirect Award: 53.5%