MBS Live Day Ahead: Settling In To Pre-Fed Trading Range; Rate Cushions Getting Thinner

With the exception of a surprise stimulus plan announcement or a huge departure from expectations in certain economic reports, the bond market is locked into its final approach pattern ahead of tomorrow's Fed announcement.  This involves a range of .87 to .96 in 10yr yields--one that's unlikely to change before tomorrow afternoon.  

That range is determined by the highs and lows from last week, but .96% has been in play since June when it turned away the summer's only significant threat to ultra low/flat interest rate paralysis.  Granted, yields were slightly higher than .96% on a few recent occasions, but that ceiling provided a firm bounce last Wednesday.  Moreover, the entirety of December has thus far been characterized by one quick adjustment toward higher yields followed by a linear consolidation back toward lower levels.

While it's a good thing to see rates trending lower in linear fashion, this particular example may not warrant much enthusiasm.  If anything, it presents a bit of a risk due to the confluence of two "floors"--one of them from the .87% level above and the other from the longer-standing uptrend in rates.

All other things being equal, the positive trend of the past 2 weeks is most likely due to traders getting ready to go on a selling spree if the Fed abstains from adjusting its bond buying balance tomorrow (a reference to WAM or "weighted average maturity"--the only thing the Fed is really considering changing at the moment).  

It might seem incongruous to discuss a longer-term trend toward higher rates given that mortgage rates are near all-time lows and have undergone no such trend.  But that has everything to do with ultra wide lender spreads (i.e. "cushion" against bond market volatility) combined with an epic winning streak for MBS vs Treasuries.  Both of those advantages are mere shells of their former selves heading into the end of 2020--especially MBS vs Treasury spreads.  There's some more room left to soak up bond market weakness via mortgage lender margins, but not nearly as much as there was just a few weeks ago. 

Beyond that, we have to consider that the new normal for those margins is likely bigger than it was in the past.  We can't really know where the new normal is, but it would be a big surprise to make it back to the 'old normal' range considering the various issues facing servicing valuations post covid--issues that won't go away quickly in 2021.

Plenty of cushion left according to 'old normal,' but if we assume a mere 20bps increase for 'new normal,' rates are already troublingly close to running out of room to outperform.