We analyse how, with the Fed now poised to reverse its course on rates and intervention, the mortgage market faces new challenges and opportunities.
- Spreads survive all sorts of ups and downs.
- MBS supply on the wane, with less headwind there.
- Volatility measures reflect a weathering of the storm.
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Fading headline risk sparks tightening
U.S. agency mortgage-backed securities (MBS) surged into the half year report card as rates and vols have done a round trip back to square one. After all was said, done and defaulted on (banks), MBS survived, and the outlook isn’t half bad.
Spreads have firmed 35 basis points since those dark days of late May, with markets resuming a more normal stance. The Fed meeting of June 14th paused any rates action however, Fed Chairman Powell did later hint at two more increases by year end. This trimmed back earlier gains but, volatility remains calm and prepayments benign, cementing a supportive backdrop to embedded call buyers of MBS.
The FDIC liquidation sales of pools and structured products are well past the halfway point with only a modicum of stress being felt in the lower coupon stack of late. It seems for now, that the mortgage market has withstood all the world had to throw at it and stabilized – for now.
The MBS index for June was an impressive +46bps versus duration-neutral Treasuries, but the Total Return was -47bps as rates sold off into month end. The 2s/10s curve continued its inversion at -106.30, nearing Q1s historic level (-108). 10yr Treasury rates pushed up past 3.85%, and volatility lowered back off its May highs with 3m10y Vols (normalized) down -11bps to 107.1 as headlines and deadlines moved into the background once again.
Originator supply was virtually identical to last month at $2.71 billion per day (+2%) yet with a noticeable shift upward in coupon composition to the TBA hedges. Current production coupons have now been pushed up to be dominated now by 5.5%s (39%) and 6%s (30%) with even 6.5%s (13%) re-entering the mix.
The 30yr primary rate elevated again, this time to 6.71% (FHLMC PMMS), while Bankrate’s daily quote held above 7% at 7.03%.
Overseas demand dealt with a new issue; the weakening Japanese Yen which has two outcomes; the first being naturally the cost of foreign goods are more expensive yet secondly, investing in say, US MBS is a good parking vehicle/hedge to falling local currency. G2/FN swaps were flat on the month, btw.
Market perspective – Supply No Longer a Headwind to MBS performance
The landscape and backdrop to MBS agency markets have changed dramatically over the past several years, as shocks to interest rates have either aided or inhibited mortgage lending originations. This, in turn, provides either resistance or assistance on MBS spreads as the glut of supply being absorbed weakens spreads while a dearth of bonds aids tightening.
The latter phenomena are now underway for a second consecutive year as rising interest rates and hence evaporating refinance opportunities have left 95% of U.S. homeowner ‘out of the money.” As the headlines concerning economic and banking trauma have largely passed, this has set up the investor to chase a lesser supply of available bonds and hence firm up MBS spreads. Given the backdrop to the Fed, the economy, and less central bank intervention globally, the number of mortgages in circulation is expected to remain lowered.
From the table below, one can readily ascertain the reduction in issuance that has befallen lenders the past two years with column C showing the percentage reduction, year over year. Looking at 2023 so far at the midway point, it will be interesting to see if issuance even surpasses $1 Trillion benchmark level of the past 8 years. In column F (AVG Original Note rate), the effect of borrower interest rates rising 300+ basis points over the past two years has an inverse effect on MBS issuance naturally.
Source: LSEG Advanced Mortgage Analytics (AMA)
Summary
Historically, this century anyway, massive increases to MBS agency supply have been led by 10yr interest rates and ultimately secondary MBS prices and yields. There have been two benchmark refi waves; in early 2000, gaining more steam post-GFC (Great Financial Crisis) as well as the past few years when a Covid battle dropped rates 300 basis points and escalated borrowing and lending.
These two waves coincided with Federal Reserve intervention to interest rates that set the backdrop to increased borrowing and a housing explosion.
Presently the Fed is set to reverse course on rates and intervention leaving the mortgage market to its vices. This offers the opportunity to spread tightening, all else being equal and event risk muted.
Month to date
Spreads have firmed as the month progressed, leaving both the Fed decision and bank trauma well in the rear-view mirror. The final two weeks have taken us to our present levels, with the 30yr current coupon (30yr CC) rising 11 basis points to 5.59%, OAS firming 14 basis points (36.1), ZV (Zero Volatility) narrowing 7bps to 156.2, and the closely followed correlation to 5&10yr Treasury tightening 17 basis points from the prior month’s wides to +161.7.
First Half of 2023
From the start of 2023, and coincidentally the first two quarters of this year, spreads are not as impressive as from the past month yet well off the wides of a few weeks ago.
Keep in mind, the market went through Fed dis-intervention where rates were periodically raised, as well as Q1 banking failures spiking volatility levels.
As a result, the 30yr Current Coupon rose 25bps, OAS spreads widened 18bps, ZVs were out 23bps, and vs the 5&10yr treasury blend +18bps in a decent recovery off the low points of a market experience a decent degree of turbulence, since surmounted.
