The Day Ahead: MBS Considerations on Watt Confirmation; 10yr Treasury Auction

Yesterday

- Bond markets saw steady, grinding improvements overnight

- Short covering and technical targets provided more motivation than fundamentals

- MBS set their trading range for the entire day in the first hour

- Fannie 4.0s added 8/32nds and rates hit best levels in Dec

- Budget deal and Watt Confirmation after hours.

Today

- Yet again, no significant economic data

- But 10yr Auction is a moderately important event

- Potential "risk on" trading from budget deal

- Watt confirmation not really a factor for production coupons / rate sheets

Strategy

The big news for mortgage markets out last night is the confirmation of Mel Watt to take over for Demarco as FHFA Director (technically, Watt will be the first "Director" as Demarco was the "Acting Director").  While there is ample speculation about Mr. Watt's likely priorities in the role, we not only have zero present-day clues on policy leanings, we actually have comically firm evasion of any preemptive decision-making (as it should be!) from WSJ.

The meaty bits of that interview can be summarized in Watt's own words in response to the question of his biggest differences with Demarco: "I don’t know that any decisions that I would make would be different from the ones that he has made."

So not only are we missing any clear signal on Watt's intentions, but the topics on which there is speculation are more relevant to MBS coupons that are less relevant to lenders' present-day rate sheets.  That's because principal forgiveness and more aggressive HARP guidelines will affect the prepayment speeds of higher coupons--those not currently playing a significant role in determining current rates.

Faster prepayment speeds on higher coupon MBS have a negative impact on price.  Actually, any MBS pool purchased over par 100-00 becomes less valuable the faster it pays down because the investor is counting on the monthly interest income to outweigh and offset the premium they paid for the loan.  For instance, if the price of an MBS coupon is 102-00, and the investor will get 100-00 back when the pool pays off, they'd like the pool to stick around long enough to supersede that 2 point premium (102-00 minus 100-00 = 2). 

The opposite would be true if we were considering MBS purchased at a discount.  For instance, if an investor paid 96-00 for a particular pool, they'd be absolutely thrilled if the whole pool paid off because they receive PAR 100-00, thus making a quick 4 points (100-00 minus 96-00).  Note: this was a bit of an oversimplification, but the more complicated version wouldn't change the concepts.

Back to the business day, which is rather uncomplicated.  There's nothing going on in the morning apart from the with-us-as-always MBA Mortgage Market Index at 7am--not a market mover, but always interesting.  The afternoon is anchored by the 10yr Treasury Auction.  This is certainly more relevant to bond market momentum than yesterday's 3yr Auction, and if Treasuries manage to stay strong before and after, it could be a major giveaway as to how much further the post-NFP correction could run.  To that end, I highlighted a few of the more bullish resistance targets in the technical chart below.

Charts

First, follow the white dotted lines to see the bullish divergence between the Relative Strength Index (a technical study that measures momentum) to see how momentum remained more flat while yields were rising.  When there is disagreement between those two sections of the chart, it's a "divergence" (either bullish or bearish, in this case, bullish) and acts as a clue about waning momentum.  In other words, yields were heading higher, but that move wasn't corroborated by momentum.    Then note the teal circles, based on the mid-point of the trend channel and the mid-point of the Bollinger Band study (also the 21 day moving avg).