MBS Live Day Ahead: Fed Starts Buying 1.5 MBS Coupons Today. Does It Matter?

Let's do the simply-worded conclusion right up front.  For fans of low rates, the Fed's inclusion of 1.5 MBS (30yr) is a good thing, but not some new and wonderful guarantee of ongoing improvement.  It's more of a byproduct and less of a root cause.  It's a sign that MBS have finally caught up to levels that make sense and that lenders have finally cleared enough of the pipeline backlog to offer rates they could technically have offered months ago. 

But those rates didn't make a lot of sense to offer when 2.0 UMBS was the lowest coupon bucket they could fill (if that's confusing, check out the MBS 101 series in the MBS Live knowledge base.  Also make sure you understand which rates go into which coupons). 

Unfortunately, it's always a slow, careful slog when it comes to the mortgage market creating a new, lower coupon even though it's a logical byproduct of the decades-long downtrend in rates.  Unlike most of the past 30 years, the Fed is now the dominant source of liquidity for new MBS origination.  That means that until the Fed is officially buying a new, low MBS coupon, that coupon is forced to exist in the shadows to some extent, biding its time until it has gathered enough strength to make its presence felt.

Incidentally, the "shadowy existence phase" of the 1.5 coupon was the fastest we've ever seen.  2.0 coupons were fast in their own right as they were forced into the spotlight by the pandemic (i.e. the bond rally was so big  as to make the necessity for 2.0 coupons completely obvious).  Here's the brief life story of 2.0 coupons (they existed as early as late 2019, but didn't become viable until coronavirus).

Contrast that to the veritable multi-season Netflix original conveying the saga of the 2.5 coupon's rise to power.  We'll use the 2 point line (a 2 gap in prices between MBS coupons--in this case the 2.5 and the 3.0).

The tale of the 2.5 had a bittersweet ending.  After waiting 6 years to take the throne as the dominant MBS coupon (thanks to the 2019 rally and the trade war), it found itself quickly usurped by 2.0 coupons out of necessity.  2.5 coupons were just too high to accommodate the rates that were clearly set to be a reality post-pandemic.  By the time the chart above breaks up and above half a point, it's a sign the king is getting old.  But we already know how that story ends based on the first chart showing the 2.0 coupon's rise to power (and its stable reign starting as early as May 2020).

Now after just 5 short months, an heir who wasn't even alive in May 2020 is already coming for the throne.  The torch hasn't been passed yet (price gap is still over 2 points), but rest assured that if lenders weren't forced to keep rates higher due to capacity constraints, 1.5 UMBS coupons would be wearing the crown (or carrying the torch?  Metaphor indecision...).

 In other words, lenders are finally writing enough loans in rate ranges that create enough volume for 1.5 coupons to become a more liquid part of the MBS market.  The Fed is responding to something you already knew the moment you saw that you could quote 30yr fixed rates in the 2.5-2.625% neighborhood.  Granted, that's not the majority of the market right now, but--for purchases anyway--it's getting pretty damn close.  If we get to a point where refis are 2.625% and purchases are 2.125-2.25%, you'll then see 1.5 coupons closer to that 1 point gap.  At that point, they'd be the only game in town when it comes to following MBS prices for the purposes of identifying intraday rate sheet risk.

So why don't we show them on MBS Live yet?  Simple.  They're still getting their sea legs.  As recently as yesterday, they gave a very convincing false alarm for reprice risk.  And while we should fully expect that behavior to calm down now that the Fed has included them in its buying operations, it would be irresponsible not to allow a few more days of track record to make sure there are no repeats of September's behavior.

Bottom line: 1.5s have been trading more and more recently, but without several of the benefits enjoyed by 2.0s and 2.5s.  One of the most important benefits is that of Fed sponsorship, and that is in play as of today.  As long as the broader bond market doesn't tank in a major way after the election, 1.5 UMBS should be worthy of being considered alongside 2.0 UMBS by the end of next week.  And if bonds improve after the election, 1.5s will quickly become the new king.  

Beyond all else, keep in mind that the Fed's decision to buy 1.5s doesn't carry any implication about interest rate momentum going forward.  It is a reaction to something that already happened.  The most optimistic thing you could say about it is this: If the broader bond market continues to improve, the Fed's decision to buy 1.5 coupons means that mortgage rates will have a slightly easier time keeping pace with the broader bond market rally.