MBS Live Commentary: Introducing 2.5% MBS Coupons

The title is a bit misleading.  2.5% coupons are nothing new--especially if we're talking about 15yr MBS.  Even in 30yr MBS, 2.5s were being traded as far back as 2012.  This is only logical considering the prevalence of 30yr fixed rates in the low 3% range at the time.  

But while 2.5s were trading, they were never in the same league as 3.0 coupons in terms of volume and liquidity.  Even now, as 2.5s are enjoying another resurgence (as they did in 2016), they are still valued based on math applied to 3.0s.  In essence, 3.0s are a known known--a rosetta stone of MBS price discovery that allows traders to arrive at a value for other coupons without actually being able to trade those other coupons as readily.  Because of this, it hasn't made any sense follow 2.5 prices.

DISCLAIMER: It STILL doesn't make as much sense to follow 2.5 prices compared to 3.0s.  But I'm going to let you do it anyway (if you're an MBS Live member) because, frankly, it's easier than continuing to explain why it doesn't make sense.  So I'm telling you right now: it still doesn't make sense.  Not yet... But we're getting there.

Today's chart shows TBA MBS volumes (daily) in 3.0 and 2.5 coupons.  As of yesterday, for instance, there were $170 billion of 3.0s traded compared to fewer than $20 bln 2.5s.  Granted, this includes a LOT of 3.0 MBS that have long since been originated compared to almost-exclusively-new 2.5s, but even when we look at the number of trades, there's still a wide gap between the two.

You probably noticed the gap in the number of trades wasn't so wide in early August.  This was a product of timing.  Recall that the first week of August saw a massive and unexpected bond rally.  This took the MBS market from being on the cusp of even needing 2.5 coupons to a bonafide supply shortage.  The fact that monthly coupon settlement was days away only added to the chaos.  More simply put, the huge rally made lenders and MBS traders alike collectively say "oh crap, we're going to need some 2.5s, and quickly."  This applied both to sellers who needed to fill trades and buyers who saw the attractive valuations that are typical of an MBS coupon that is just starting to trade in measurable numbers.

That early August surge was, thus, understandable.  By itself, it wasn't enough for me to consider posting 2.5s, let alone using 2.5s as the price I mention when writing commentary.  The gradual increase in volume over the past 2 weeks is more promising. In fact, even if 2.5 volumes merely held flat, they would have been doing better than they did in 2016.  

Long story short, it's finally time to retire 4.0 coupons from the dashboard.  If bonds sell off enough, we'll switch it back.  Just understand that there's no PREDICTIVE significance to any of these developments in volume or the fact that I'm changing the composition of the dashboard.  I remember wanting to believe that way way back when I first started learning about MBS, but the fact is that the broader bond market (i.e. Treasuries) will continue to set the primary tone.  MBS will trade on spread.  That spread will vary, but mortgage rates won't ever go in the opposite direction from Treasuries for very long (barring something as catastrophic as a 2008-style mortgage-specific meltdown).  Bottom line: rate momentum is rate momentum.  We're keeping an eye on 2.5 prices mostly just for fun, and for those who want to be ULTRA conservative (read: "too jumpy") when considering negative reprice risk.