MBS Live Day Ahead: Slow Start. Green Start. MBS Outperforming

Bonds are starting the day in decent shape with 10yr yields just slightly lower than yesterday's latest levels.  The bigger story is MBS outperformance though.  When compared to the typical Treasury benchmarks, MBS yields are lower than they've been in decades. 

What's a typical Treasury benchmark?  We have spent vastly more time using 10yr yields for this purpose, but a blend of 5 and 10yr yields is generally a more appropriate comparison as MBS durations tend to consistently undershoot the 10yr time frame.  The following chart shows how MBS yields (not prices!) have moved relative to 10yr yields.  

As you can see, they're within 20bps of each other.  That's INSANELY tight considering 2012's record was over 40bps.  In fact, it's so tight that it lets us know we need to look elsewhere for relevance.  It wouldn't make much sense to buy bonds with prepayment uncertainty for a mere 20bp premium over guaranteed money.  Once we sprinkle 5yr Treasuries into the mix, things look slightly less insane.

This is both good and bad.  On one hand, the ability to continue outperforming--even after apparently hitting resistance earlier in the year--has helped MBS make gain on days when Treasuries were flat or weaker.  On the other hand, one must assume there's a limit to outperformance, even if the boundaries have been stretched significantly.  After all, none of this would be possible without the Fed's ongoing commitment to MBS purchases.  

So what happens when these lines bounce and head higher?  Fortunately, the highest probability catalyst for a spread spike would be another Treasury rally.  In that case, TSY yields would fall and MBS yields would simply fall slower.  Thus, mortgage rates would be steady-to-lower and no one on the origination side of the market would much care about MBS spreads. 

There is one other scenario to mention: an eventual tapering of the Fed's bond buying programs--but it's hard to say what the impact would be on spreads.  Reason being, the 2013 tapering fell hard on the heels of the MBS-specific QE3 program, so spreads might have been correcting anyway.  Additionally, Bernanke mentioned the goal to return to a TSY-only portfolio numerous times whereas Powell hasn't said anything of the sort recently.  Indeed, just this week, he reiterated the need to buy both TSYs and MBS.  The only risk to Powell's MBS largesse is in the event the Fed concludes it's causing stability issues in the housing market.