MBS LUNCH: Support Levels Holding While Stocks Rally
Beyond stop out selling...activity in the 10 yr TSY note has been somewhat subdued today. Here is a chart of the 10 yr Sept. Futures contract. Notice the first volume spikes as data was printed and then the second as stop out levels were reached....these are "STOP LOSS" levels set by traders to protect remaining profits from being lost.
PS...Those two sell offs generated more volume that this chart alludes to...so far we've seen 625,000 10 yr contracts traded. The volume values are a bit distorted but I think you still get the picture. ALL SELLERS!
When looking at yield, the 10 yr note is hovering around 3.65%...this is where we began the day on Friday so it should be of no surprise that this is the yield level that profit takers took us to following better than expected econ data around the globe.
"Rate sheet influential" MBS have given back Friday's rally, however mortgages are holding tough relative to their benchmark big brothers as current coupon MBS/TSY yield spreads are a few bps tighter. Although the FN 4.5 is down 21/32 (21 ticks)...PARNERTIA is proving strong support.
This is no surprise given the price behavior of the FN 4.5 over the past month. Not much time has been spent over 100-00...FLOATING REMAINS SUPER RISKY!!!
Notice we keep reminding you of that when the FN 4.5 is trading over par?
Implied interest rate volatility is a few bps higher today. This is not the norm early in the month and may not continue as we get closer to NFP day.
WHY?
Supportive Event #1: Prepay Reinvestments
Each month MBS analysts and traders spend a considerable amount of time forecasting borrower refinance behavior. Borrower refinance behavior (or any action associated with paying off your mortgage) is revealed through MBS portfolio prepayment speeds. Prepayment speeds are THE key determinant in the valuation function of MBS. If prepays increase or decrease more than expected it can drastically alter the value of an MBS holder's portfolio.
At the beginning of every month, the principal prepayments from the previous month are reported. The "paid off" loan principal (of the mortgages you own) is deposited in the portfolio holders account. These funds can be reinvested!!! Depending on the interest rate environment those funds might be reinvested in new MBS....which adds funds to the demand side of the MBS market.
Supportive Event #2: Less Interest Rate Volatility
At this point in your education process I hope it has become clear to you how important the process of forecasting expected cash flows is in determining the value of any fixed income security. When pricing the value of a fixed income instrument the most important issue is predicting the future path of interest rates...or the expected volatility of interest rates over the time period in which you expect to hold a specific fixed income investment.
Future interest rates are not impossible to predict, but are extremely difficult to estimate with a high degree of accuracy. Predicting future mortgage cash flows not only depends the expected behavior of borrower refinances and new home buying trends (see explanation above)....it depends on the anticipated volatility of benchmark yields (TSYs).
Investopedia's Plain and Simple: Volatility refers to the amount of uncertainty or risk about the size of changes in a security's value. A higher volatility means that a security's value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security's value does not fluctuate dramatically, but changes in value at a steady pace over a period of time.
What does lower interest rate volatility have to do with the beginning of the month?
The US Government has scheduled the release of its Employment Situation Report (Nonfarm Payrolls) on the first Friday of every month. Without going into further detail about why....the Employment Report helps reduce the implied volatility of interest rates!
Lower implied volatility means a tighter path of expected interest rates in the future (lower option cost) which implies less risk in investing in MBS (tighter yield spread) which means investors will have stronger demand for MBS!!! Great timing considering portfolio principal prepayments will be deposited into my trading account.
Supportive Event #3: Attention to Settlement
In the TBA MBS market, at the time of the trade, the buyer and seller agree to the type of MBS (FN,FRE,GN), the coupon, and the price...they do not however provide the specific pool details of the trade. Trade settlement dates are preannounced every month by SIFMA. Two days before settlement date sellers are required to notify (notification day) buyers of the specific details of the pool that the buyer agreed to purchase from the seller. The pool details are required to meet specific standards that were agreed upon at time of trade. Two days later the trade is settled!
These events occur at the beginning of every month. As the calendar grows closer to settlement date MBS market participants begin to pay much closer attention to the TBA MBS market because a profitable opportunity may arise. This takes fixed income investors attention off of other relative value securities and focuses it more intensely on mortgage world!!!
The outlined events combined with official Fed support should help MBS coupons outperform their benchmark big brothers this week. However, regardless of "outperformance", if benchmark prices move lower...MBS prices will follow, perhaps just not to the same extent...so in the event that benchmark rates back up....reprices for the worse are still a concern. This is exactly what has occurred this morning...TSYs have sold off, rate sheet influential MBS have outperformed..but lenders have still repriced for the worse. Rate sheet reality....
Stocks continue to tick higher today as the dollar is weaker and oil has rallied almost $5.00 higher since Friday...."WAIT AND SEE" mode for fixed income.
2s vs. 5s: 150bps
2s vs. 10s: 245bps
5s vs. 10s: 96bps