MBS LUNCH: Floor Falling as TSY Traders Adjust for Supply
Trading in the MBS market reflects the disdain with which many accounts view "rate sheet influential" MBS coupons at the moment.....all indications imply the Federal Reserve is now the lone buyer of originator offerings (lenders locking the loans you lock). This is purely a function of the gyrations of the yield curve and the market's unwillingness to put ones portfolio in a position to suffer from extension risk.
Huh?
Reminder: When benchmark interest rates rise both the duration and expected life of "out of the money" (at par or below par) MBS coupons increase. The farther out of the money an MBS coupon is, the more it's duration and life will extend when benchmark rates rise. This happens because the borrowers backing the loans that make up the MBS coupon have no incentive to refinance if their interest rate is lower than current market (only borrowers can "call" MBS coupons)
Plain and Simple: MBS buyers dont want to be stuck in a fixed income investment that isn't keeping up with their benchmark's performance...if risk free interest rates move higher this implies those "current coupon" MBS buyers have the opportunity to reinvest funds in a higher yielding debt instrument...they could be earning more return/MORE CASH FLOWS!!!! Now lets apply the academic background knowledge to the current unstable/illiquid/choppy interest rate environment.
The five day rates rally we were enjoying until yesterday afternoon allowed MBS investors to move "down in coupon" into longer life mortgage coupons with a lesser degree of extension risk anxiety...demand for "rate sheet influential" MBS coupons steadily increased and mortgage rates moved progressively lower. This was mostly thanks to Treasury yields moving lower. Well...yesterday a threshold was met as the long end of the yield curve became overbought and selling ensued. Benchmark TSY yields began to rise as profit takers emerged and supply conscious traders started to make room for next week's Treasury auctions (more below). As selling intensified something very similar to "Black Wednesday" occurred...."current coupon" (negatively convex) MBS coupon holders began to SELL SELL SELL. This was a factor of the yield curve steepening.
Reminder: When the yield curve steepens (forward interest rates rise), the life of "rate sheet influential" MBS coupons grows longer. The extending life of those MBS coupons is a scary thing to investors because it means they could stuck holding an MBS coupon that is underperforming the yields of current market risk free benchmarks (bc only the borrower can exercise the embedded call option in MBS)...which brings us full circle to the previous Plain and Simple. Hence why we have seen panic-like selling of "rate sheet influential" MBS coupons every time Treasury yields start to rise...no one wants to be stuck with high extension risk MBS coupons, esepcially when market fundamentals indicate higher benchmark yields to come!
There is a bright side....
The mass exodus from long duration "rate sheet influential" MBS coupons occurred over the last 24 hours has created some bargain basement MBS prices. Last Thursday when prices fell to these levels (lower actually) we saw a slow and steady progression of speculative buying (and asset/liability matching from real money) which eventually evoled into a full on facemelting rally (even Asia jumped on board towards the end). So the upside potential for a retracement recovery remains high, but once again we must remind...any rally in MBS is totally dependant on the gyrations of the yield curve. Benchmark TSY are still providing directional guidance/leadership to MBS investors.
Plain and Simple: MBS prices are cheap, but without a rally in benchmark TSYs there isnt much room for mortgage rates to move lower. Oh one more issue to cover...investors will also be a little less willing to add new positions so close to quarter end ("window dressing").
Anyway ...onto intraday activity. In early morning action loan originators were out locking in some pipeline profits while they could (before the floor fell)...adding to the bearish fixed income bias was better than expected LEI data and the Philly Fed index (way better than expected). Yields spreads are widening in "rate sheet influential" MBS coupons...further illustrating that market participants are moving "up in coupon", shunning long duration current coupons (the ones that make up your rate sheets). The Federal Reserve has been a buyer....so whatever liquidity is left in the "rate sheet influential" side of the coupon stack has been provided by the Fed. Thank you for being there Fed! Relating this morning's market activity to rate sheet sheets....the price points where originators were locking their loans imply that higher mortgage rates are to come...that is unless TSYs rally and speculative bargain buyers move "down in coupon" again (maybe but dont hold your breath).
As Matt pointed out this morning... 101-00 on the FN 5.0 will serve as a psychological price support level. Any falls below the 101-00 price level will likely constitute an increase in "bargain buying...
tick tock tick tock...still waiting for that bargain buying!!!
Unfortunately, as previously stated (yes we are repeating this for a reason)...."rate sheet influential" MBS coupons are TAKING THEIR DIRECTIONAL GUIDANCE FROM THE GYRATIONS OF THE YIELD CURVE!!!! I say unfortunately because the 10 yr TSY note is now testing our 3.82% support level. If 3.82% fails to create "bargain buying" in the 10 yr....MBS investors will gladly sit by while the floor falls and dollar prices cheapen up. Bummer for rate sheets because it means MORE REPRICES FOR THE WORSE.
Come on 3.82%...MBS NEEDS YOU!
Why are TSY yields rising so much, so fast?
SUPPLY (and better than expected economic data)
The Treasury Department announced month end supply of 2s/5s/7s at 11 am....surprisingly the 5 yr auction amount increased by $2bn to $37bn and the 7 yr auction rose by $1bn to $27bn. In total $104bn will be auctioned . As this increase in issuance was unanticipated, the market quickly took the opportunity to push yields higher a few bps to accommodate for unexpected supply (supply/demand fundamentals). The 5 yr note has risen 9 basis points to 2.84% since the announcement, while the 7 yr note has moved from 3.42% to 3.50%. In the comments section of the last blog post we made a statement implying the increased borrowing needs of the Treasury Department may be as a result of broad based job losses and the consequential shortfall in tax revenues. Just a thought...anyone else have a theory?
DOES EVERYONE GET THE POINT WE ARE MAKING?
MBS TAKING DIRECTIONAL GUIDANCE FROM THE GYRATIONS OF THE YIELD CURVE!!!
haha I think we've made our point....
2s vs. 10s: 255 bps