MBS Live Day Ahead: 1.5 MBS Are Here! What Does That Mean? Are They Cursed?

There are no significant events on the economic calendar today, and it is the last full trading day of the last full trading week before the winter holiday season.  All that to say that trading will be heavily influenced by factors that transcend the simple notion of reacting to data/events in the market.  This can include things like "position squaring" (buying or selling to close positions), re-positioning among money managers (adjusting bond market allocations based on shifts in investor preferences), corporate bond hedging (more on that HERE), and more.  All of the above can further be distorted by late day illiquidity as some traders will do what they need to do and punch out early. 

Bottom line on markets: bonds are going to do whatever they're going to do today.  It will probably look a lot like a continuation of the same consolidation trend that's been intact for the past 2 weeks, and if it looks like something else, we'll probably chalk it up to pre-holiday-week illiquidity unless there's an obvious source of inspiration in play.  With all that in mind, let's talk about something that's actually interesting: 1.5 UMBS Coupons!

We already know that the Federal Reserve is buying a certain amount of 1.5% UMBS 30yr fixed coupons as of a few weeks ago.  That was big news, but NOT because the Fed had any particular agenda or goal to coerce mortgage rates lower.  The Fed's decision was purely a reflection of where the mortgage market is and where it's headed.  In other words, the mortgage market dictated the Fed's actions--not the other way around.  1.5 coupons are an EFFECT, not a CAUSE. 

That said, improved liquidity in 1.5 coupons definitely helps MBS valuations versus benchmarks which in turn improves lenders' ability to keep moving rates lower as their capacity constraints allow. But that will be a bigger deal when/if rates are a bit lower than they are now.  Most lenders could drop rates 20-30 bps without breaking a sweat, even if they'd never heard of 1.5 coupons.

Are 1.5 coupons the ones to watch?

First off, if you're curious as to which MBS coupon is the best one to follow for reprice risk, it's more or less imperative that you read this at least once: How Do I Know Which Coupon to Watch?  The shortest answer is "yes."  I wouldn't add them to the MBS Live dashboard if they weren't relevant to lender pricing considerations.  But that doesn't mean they're necessarily better than UMBS 2.0 coupons just yet.  They're merely "different."

Any time we're dealing with a new frontier in low MBS coupons, the lower/newer coupon will always be jumpier and more sensitive to broader bond market movement.  This is easy enough to see right this very moment as the intraday trading range is 4 ticks for 2.5 coupons, 5 ticks for 2.0 coupons and 6 ticks for 1.5 coupons.  It won't always be so nice and linear, but you get the idea.  1.5 coupons are living life in the fast lane.  Expect them to cover more ground in both directions when bonds are on the move.

The takeaway is that following 1.5 coupon for reprice risk, etc. will result in potentially premature panic/concern when it comes to some lenders.  To be sure, if you work with or for a lender who is notoriously jumpy with rate sheets, I would definitely give 1.5 coupons at least 50% of my attention.  On the other hand, if your lender rarely reprices (even when others are), following 1.5 coupons is likely to result in too many false alarms.

Is there a 1.5 coupon curse?

One of our favorite MBS Live campfire stories is that of the 2.5 coupon curse.  Back in the day when 3.0 coupons dominated and 2.5s were just coming into their own, it seemed that almost every time we added 2.5 coupons to the MBS Live Dashboard, the bond market would reverse toward higher rates and we'd be forced to take 2.5s down.  More than anything, this reflects the cyclical nature of momentum in the bond market.  Specifically, a certain amount of rally momentum is increasingly likely to give way to a negative correction--all other things being equal.  As such, by the time bonds had rallied enough for 2.5 coupons to make the cut, they were at a higher risk of a technical reversal.  When those reversals showed up, 2.5s were always at the scene of the crime, and thus the legends grew.

This was never an issue with 2.0 MBS coupons because the pandemic-driven bond market mega-rally made it immediately apparent that 2.0s wouldn't be going anywhere quick enough to dissuade the MBS market from relying on them as the production coupon of choice.  They STILL haven't passed that torch to 1.5 coupons, but they are rounding that final corner and 1.5s are holding out their hand, ready to take lap or two as rates "race" lower (like a turtle... due to lender capacity).

But are 1.5s still cursed because of the momentum/technical issue mentioned above?  Consider this: past episodes of the curse happened when MBS and Treasuries were significantly more correlated than they have been in the past few months.  In other words, while MBS are only a quarter point away from their all-time highs, trading at their best levels since early August, Treasury yields are closer to their WORST levels in months over the past 2 weeks.  And it's Treasuries much more than MBS that will precipitate technical shifts in bond market momentum.  Bottom line: if we do see a nasty spike in bond yields, it wouldn't have anything to do with timing or technicals.  It would require some big, new news--either an unexpectedly quick/robust stimulus package, a surprise democratic sweep in Georgia senate elections, or a mysteriously mind-boggling reversal in the trend of lackluster economic data.