MBS RECAP: New 2011 Price Highs

Even though the economic calendar is a bit lighter next week, things should get even more exciting. That wouldn’t take much considering this week has been largely sideways with the exception of today's unexpected breakout. Today does indeed look like the “lead off” in a new directional trend following the previous sideways trend. Could it really be a trend that sees the bond market rally beyond current levels? Does the 10yr note below 2.85% hold? Do new year to date MBS price highs move even higher? Monday and Tuesday contain ISM Manufacturing, Construction Spending, and Personal Consumption/Expenditures Reports, but it would be fair to assume that the August 2nd debt-ceiling deadline will trump all. Even into Wednesday’s ADP Employment numbers, political headlines will be the constant wild-card. One thing to consider is that August 3rd will be the first day after “the deadline,” and is also a day in which the following week’s Treasury auctions will be announced. Not much by way of economic data on Thursday… Just Claims really, but there’s sure to be plenty of trading going on as markets prepare to synthesize the July Employment Situation Report on Friday in some sort of proportional balance with whatever happens to be the prevailing state of the debt-ceiling debate. There is a lot of potential for directional volatility next week.

Default would be political suicide for all parties involved, making it a highly unlikely event. But if we were to default on a coupon payment, there would be a huge margin call followed by massive deleveraging in the short-end of the yield curve and a major repricing across the credit spectrum, which would be intensified by MBS duration shedding (curve gets sucked into convexity vortex. Lower and wider we go. This is "snowball selling"). In our opinion the more probable scenario is Congress fails to come to an agreement by August 2nd , forcing Treasury into so called “prioritization mode” to avoid default, which would soon be followed by another band-aid bill to raise the debt ceiling by just enough to get us into 2012 where Republicans would proceed to relentlessly hammer Obama’s tardiness on the issue before elections. If that scenario were to play out we wouldn’t necessarily be looking at a credit downgrade. It’s still 50/50 at that point, totally dependent on the credibility of whatever plan is being debated at the time and how quickly Congress acts to raise the debt ceiling (Congress would need to act quickly though because Treasury makes around 3 million payments per day and does not have the systems to "prioritize" payments). This would likely lead rates higher but would not result in all out capitulation in the bond market. More simply put, a jump in rates would be temporary. It seems like all you can do is stay nimble and hope politicians are smarter than they act. Unless you've got more than 30 days to float, this uncertainty makes "locking on application" a favored strategy.

Production MBS coupons rallied far and fast today. The Fannie Mae 4.0 MBS coupon just closed +26/32 at 101-19, a new 2011 price high. While one might say it's been a real "facemelter", loan pricing isn't exactly keeping up with the bond market rally. Rate sheets improved by 44.4bps on average this morning but are still between 25 and 50bps below the best rebate offers of the year (seen on June 27th). This makes for a difficult decision heading into the weekend. Benchmark Treasuries have yet to show fear over the potential for a U.S. credit rating downgrade next Tuesday. Clearly this is surprising as politicians seem nowhere near a deal on the debt ceiling, which implies lawmakers are ready to play chicken with global markets. From that perspective we're still dealing with an "anything can happen" environment where volatility reigns supreme. If your secondary desk has repriced for the better and you're nervous like we are about what happens on August 2nd, it makes sense to lock. If you've got room to float, haven't seen reprices for the better yet or have no problem gambling with your income and the borrowers rate quote, there is a chance that bonds continue to rally next week. Investors have no other safe asset to put money in besides U.S. Treasuries and Gold (not without initiating a major reallocation trade). Right now it seems like investors are assuming the U.S. will not default on it's debt. So business as usual as long as coupon payments are made? Like we said, "anything can happen".

(Reuters) - A top Senate Democrat said on Friday he hoped Democrats and Republicans would reach a deal by day's end on a compromise bill to cut federal spending and raise U.S. borrowing authority. "We hope a deal can be had by day's end" with Senate Republican Leader Mitch McConnell, Senator Charles Schumer told reporters. Such a deal would clear the way for the Senate to begin debating legislation over the weekend and pass it by Tuesday, when the Treasury Department thinks it will exhaust its current borrowing authority. (Reporting by Andy Sullivan; editing by Todd Eastham)

Even when today's stock rally was at its best, bonds still didn't seem too phased. 10yr notes rose to just barely touch 2.86--a much smaller correction than we'd normally expect given the circumstances and levels. Now they're back down to match the low yields from earlier in the day in the mid 2.84's. MBS have mimicked the move as well. After correcting a few ticks from their best levels of the day, they're back within half a tick (1/64th) at 101-12. There's no remaining economic data for the day, but plenty of opportunity for market moving headlines surrounding the debt ceiling debate. If you were to see a reprice right now, it would be for the better. Not commenting on the likelihood, just that we're not at risk for reprices for the worse.