MBS Update: Nervous Nelly

The MBS stack traded in a tight range today

FN 4.5: -2/32 to 100-27

FN 5.0: -2/32 to 101-21

FN 5.5: Unchanged at 102-08

FN 6.0: Unchanged at 102-22

The main theme today: STAY IN HIDING ahead of the FOMC meeting. The yield curve flattened out with the long bond closing at 2.954 and the 10yr at 2.504. MBS trading was heavier than expected with the flow tilted towards selling. Treasury buying prompted further MBS spread widening, but as we have been pointing out daily...when MBS spreads have gapped out, the Treasury department has stabilized MBS bids by purchasing excess MBS supply. FYI this buying this is not part of the $500bn MBS money announced early in December. We don't get that aid until late 2008 early 2009.

The big question of the day from the street has consistently been:

I AM NERVOUS ABOUT THE FED MEETING SHOULD I LOCK OR FLOAT?????

Don't worry you aren't the only person who is nervous. If you have a decent pipeline that you have been floating over the past two weeks you should have some nice cushions built up. We always advise managing your risk by doing some profit taking when possible. If locking now will provide enough income to get your bills paid then go ahead and lock some loans in...take the money while its on the table. Find your breakeven point and stick to the numbers! You can always lock with an investor who has a strong float down policy. For those who are feeling added anxiety after an apparent MBS stall....don't panic. The Friday into Monday sell bias reflects normal originator hedging and a pre-FOMC "just in case" positioning. The short term marginal "up in coupon" sentiment is not good reason to frantically lock all your loans tonight. But if you have a few loans that are reliant on rate then lock up...JUST IN CASE. 

There are big implications when the Fed Funds rate is changed. A higher Fed Funds rate makes banks less willing to lend out money, but that isn't on anyone's radar at this stage of money deflation. What we care about is a lower Fed Funds rate. Lower target overnight lending rates allows banks to borrow funds at a cheaper cost, this gives them the ability to borrow more and therefore lend more relative to their required reserves. The intent is for borrowers (big or small) to take advantage of cheaper credit by puting money back work in the economy...yah for everyone. Unfortunately this strategy hasn't been effective thus far which is why the Fed has resorted to all out Quantitative Easing. Moving on...

One of the main challenges of lowering the overnight lending rate and increasing the pace money creation is controlling INFLATION. Well inflation isn't much of an issue at this point so in terms of MBS TAPEBOMBS an added inflation premium is nowhere on our radar. We do however hope that the FOMC is discussing the inflationary ramifications of the intense re-flation of the US Economy. For now any inflation anxious verbiage in the policy statement  would be muy bad for bonds. But again we don't expect inflation worries from the Fed, so don't worry about this potential MBS value eroder.

A less MBS specific issue could arise in regards to the impact of a rate cut on the global demand for US Fixed Income securities. After the ECB once again took a hard stance on further interest rate reductions (last week) there is the viewpoint that a global investor may find better yields in another bond market...which would rouse bond sellers and increase the real risk free rate that all interest rates are based on. The $28.7 billion decline in foreign holdings of US fixed income securities (per Treasury International Capital report) validated this is indeed already a problem, but we aren't too worried even though that is a record decline. Risk free yields are still at record lows (thank you flight to safety) and the MBS coupon stack is quite compressed. So we will continue to operate on the premise that that our financial policymakers haven't been feeding us a load of malarkey regarding their continued participation in capitals markets. Ben and Hank have promised MBS spread tightening and a concentrated  focus on the stalling of foreclosures, all we can do is to continue to trade on their word...

What MBS market participants will be waiting to hear is any verbiage regarding the outlook for housing and its relation to the $500bn that is expected to be spent on MBS. Will the Fed spend more towards the beginning of the program? Will the Fed spend money as needed? Will the Fed let the market try to work out its problems on its own and wait for panic again? These are all interpretations that will be made based on the policy statement. That was in best to worst order by the way..

If the Fed implies they will remain intently focused on fixing the problem at hand....foreclosure intensification and further asset devaluation....then MBS market participants should feel that our $500bn will be put to work as promised....and sooner rather than later! Any verbiage that leads us to believe that the Fed will continue to provide MBS liquidity is a positive. This speculation would give real and leveraged MBS investors more incentive and support to jump into the "down in coupon" buying trend. Here it is plain and simple: we are basically looking for some reinforcement that the $500bn promise will be fulfilled...we need our egos stroked!!!In terms of your rate sheets this would allow lenders to take a sigh of relief and would also provide the justification necessary to allow for the passing through of a portion of the cushion that has  been worriedly baked into street rates...they wont open the flood gates but rates will improve. If this is what transpires tomorrow the float boat will be sailing with the wind at its back.

This is best case scenario...and a version of what we expect to hear. In terms of worst case...allow me to pose a question. Do you honestly think the Fed will backpedal from its most recent rescue strategy at this point in the game? After all that media attention? After all the trades that have been placed on these assumptions? After all the Treasury and Fed rhetoric? We really don't think this will be the case, so put the worst case scenario out of your head. We strongly believe we will see that $500bn and that mortgage rates will continue to go lower...to illustrate one of the possible MBS negative scenarios here is the meat of the October 29 FOMC Policy Statement:

"The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit."

We expect a similar statement and hope for additional housing related verbiage.If no mention of weakening housing is made than just maybe, traders might regress towards those memories of unfulfilled TARP promises and sell sell sell, but would it matter in the long run? We STILL feel the Treasury department would continue its campaign to eradicate excess MBS supply. Rates HAVE TO BE LOW for any housing progress to be made...so in reality, with the worst case out of our minds, even a slightly negative FOMC statement wouldn't have long term "up in coupon" implications. We remain floaters into 2009, if the money to pay the bills is on the table and you NEED it...don't let it sit out there right up to closing though. Take your money when we start to tell you profit takers and hedgers are looming near...

Oh yeah in terms of the actual rate cut....Worsening labor market conditions and business activity leads us to agree with the consensus expectation that the FOMC will cut its target overnight lending rate 50bps to 0.50%.....even though this is one of the last bits of ammo left in the Fed's conventional policy making arsenal. Of course, overnight lending rates are already near 0.00%, will a 50bp cut spur bank lending?It hasn't aided progress to this point (well if progress is curbing failure then rate cuts have been progressive). Unfortunately Ben has created a monster, and you cant just stop feeding that monster, which is why we expect a 50bp rate cut tomorrow....

Check out the Effective Fed Funds rate...it is already below 0.50%

Source: New York Fed

Besides the FOMC meeting tomorrow:

November CPI early in the session. Expectation is CPI will have declined 1.3% and the Core number will be close to the same or just a smidgen higher (0.1%)

Housing Starts will be released as well. We don't expect much positivity in this report. Expectation is  a fall of 6.5% to 740k.

Automaker drama continues as well...