The MCT Review: Market Commentary Week of February 7

The U.S. Treasury Yield Curve Flattens

As we draw closer to the next FOMC meeting in March, when the committee is expected to announce a federal funds rate target increase (the first of several this year) and another pullback in daily MBS purchases, short-term rates have gone up this year relative to long-term rates. With the Fed expected to raise the overnight Fed Funds rate and Discount Rate several times this year, short-term rates will likely head even higher, and long-term rates may not move as much, leading to a flatter yield curve. 

Many of you know that the shape of the yield curve is determined by plotting yields of bonds with equal credit quality but different maturity dates (e.g., 2-year Treasury note versus 10-year Treasury note versus 30-year Treasury bond). The yield curve normally exhibits convexity, or slopes upward, because long-term debt instruments should, in theory, yield more than short-term debt instruments as a result of a higher risk and liquidity premiums.

Normally, the 10-year Treasury yield is the “benchmark” that those concerned with mortgage rates watch. Still, the belly of the curve – referring to durations from roughly three to seven years in the middle of the curve – is essential because MBS traders follow shorter maturities. That is because the expected duration of a typical 30-year mortgage is closer to those time periods. When the yield curve flattens, the belly of the curve sees the most volatility. 

An inverted yield curve (where short-term rates are higher than long-term rates) has historically been a strong recessionary signal, preceding every recession since 1950 by seven to 24 months. Additionally, the yield curve remained in negative territory for several consecutive months prior to the last three recessions. However, recent Fed research indicates the 2s-10s spread may not be the best signal of an upcoming recession. It suggests the spread between the 3-month Treasury bills and 18-month Treasuries could be more predictive. Keep in mind that even if the yield curve does not invert, a flattening yield curve is also a predictor of slower economic growth.

What does this flattening yield curve ultimately mean for the mortgage industry? Well, it is both good and bad. On one hand, it is a signal that the market believes the current level of inflation is temporary and will return to its historical 2% level. This would eventually mean downward pressure on mortgage rates, leading to more refinances and better affordability for home buyers. On the other hand, a flattening yield curve is also a signal that economic growth will decelerate as well, which would hurt demand for homes. We could see a rate situation where adjustable-rate mortgages (ARMs) and 30-year fixed-rate mortgages have similar coupons. 

The recent flattening of the yield curve has occurred in anticipation of both the Fed raising rates in the short term and slower economic growth over the longer term, both of which are reactions to the main challenge facing the U.S. and the global economy in the next decade: the threat of faster-than-expected inflation. Keep in mind that there are a number of factors other than market expectations about the future path of interest rates that are influencing long-term yields. The Index of Leading Indicators is well in positive territory, the stock market remains supported despite a recent correction, and employment growth is positive, as evidenced by January’s strong payrolls report. 

An upward sloping yield curve rewards investors for the longer-term risk of buying Treasury securities. The bigger concern than the yield curve flattening is twofold: that much of the demand for Treasuries is artificial and that the Fed has already missed the boat when it comes to fighting inflation. The size of the Fed’s balance sheet relative to the economy is larger now than before previous recessions and has manipulated the yield curve as a result. Expectations are that the Fed will stop tightening before deterioration in the economic fundamentals could spell the end of this current economic expansion and risk a recession. Join us next time as we discuss the Fed’s impact on future MBS pricing.

Rising MSR Values

The start of 2022 has brought with it higher mortgage rates, but that also means the benefit of higher MSR values. While the industry is always focused on origination volume, now is also a great time to take a deeper look at your MSR strategy. MSR can act as a natural hedge against rising rates for mortgage companies. Companies may hold the asset to pay off before maturity, or only sell on an as-needed basis to accomplish quarterly earnings. 

Whether you are retaining or releasing the majority of your MSR (and MCT can certainly help with that decisioning), many of our clients are hedging any drop in origination volume with the added profitability of the MSR asset. As mortgage origination business dies down a bit due to higher interest rates, servicing revenue goes up and can supplement any loss of revenue from less business coming in. The value of the MSR asset has risen along with expected duration because higher mortgage rates lead to less payoffs.

Determining the value of the MSR asset is paramount, both for retain versus release decision making as well as enterprise goals. You may choose a long term retention strategy solely because you don’t want to pass customers to competing companies that may leverage your client base for cross-sell or recapture opportunities. Or maybe you have come to the conclusion that servicing MSRs can be complex and expensive, potentially with significant opportunity cost. 

There are prospective opportunities afforded by both retaining and releasing MSR, but with a myriad of assumptions that go into deriving the underlying MSR value, considerable judgment is not only recommended, but required. One incorrect assumption can materially affect the estimated fair value of the servicing rights. Some key behavioral assumptions used in estimating servicing income are prepayment speeds, delinquency rates, and discount rates. On the revenue side, it is important to incorporate late fees, contractual service fees, ancillary income, and float income.

We are firmly in a rising rate environment, which means that those that previously sold MSRs jeopardized future earnings. Before making the decision to retain or release MSRs, it is important to understand how the decision may affect both long and short term earnings. Once a portfolio of MSR note rates is already below current market rates, the incentive to refinance is relatively unchanged even with further large market rate increases. At that point, upside gain in MSR value is limited and selling a portion of MSR holdings can be either strategic or need based.

Something that needs to be addressed are the implications that come along with servicing responsibilities, such as accounting for fair value benchmarks, changes in the regulatory environment, and increased servicing costs on top of already thin margins. 

Maybe you want to sell to recognize the spread between current Lower of Cost or Market book basis and Fair Market Value. That consideration, along with the potential need for impairment testing, amortization, and possible risk volatility mitigation, makes managing the MSR asset complex even for those with the necessary resources. While delegating those responsibilities to a third party is a valid option, others not wanting to manage the complexity of this asset may decide that a released strategy is in their best interest.

It might be helpful to pivot to a more dynamic strategy for MSRs this year. MSRs are a liquid asset, and making a decision on when to cash in will impact future revenue streams. Choosing between the servicing grid and the cash flow model is something you should highly consider. Servicing grids are only updated monthly or quarterly making them not a very flexible option, though they are a common and easy to understand option. Cash flow is more accurate which can help improve hedging performance based on more legitimate predictions. 

Looking for more help? Whether you are getting your agency approvals, selling through co-issue, or actively growing your portfolio, MCT offers a suite of tools along with an experienced team to help you with all your mortgage servicing rights needs. Choose the combination of services to achieve your MSR risk management goals.

10-Year Treasury Yield Curve

Compare this chart with the mortgage rates chart to see how the 10-year treasury and mortgage rates are correlated. Read more below to learn how mortgage rates are tied to the 10 year treasury yield. View raw data on U.S. Department of the Treasury website.


Mortgage Rates Today

The current MBS daily rates are shown below in this chart for 5/1 Yr ARM, Jumbo 30 Yr, FHA 30 Yr, 15 Yr Fixed, 30 Yr Fixed. Sign up for our MBS Market Commentary to receive daily mortgage news in your inbox.

About the Author

Robbie Chrisman, Head of Content, MCT

Robbie started his mortgage industry career with internships during high school and college at Peoples National Bank in Colorado, and RPM & Bay Equity in the San Francisco Bay Area. After graduating from The University of Texas at Austin with a degree in Finance in 2014, he went to work at SoFi, where he rose to Director, Capital Markets assisting in the creation of SoFi’s residential mortgage division before leaving to work for TMS in Austin, Texas. From there, he went to work for FinTech startup Riivos in San Francisco and now is the Head of Content at Mortgage Capital Trading (MCT) in San Diego.

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Previous Weekly Market Reviews by Mortgage Capital Trading (MCT)

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MBS Weekly Market Commentary Week Ending 3/31/23

The market reaction went a little “too far, too fast” in regard to the Fed policy pivot. We witnessed the coupon stack (i.e., the price spread between TBA coupons) decompress in more than a trivial manner in a short period. However, the primary mortgage market has been largely reluctant to follow the Treasury rally, and mortgage rates have ultimately not dropped by the same amount as Treasury yields.

MBS Weekly Market Commentary Week Ending 3/24/23

The FOMC raised its benchmark rate by 25 basis points to a new range of 4.75%-5.00% on Wednesday, a middle ground policy move made in the hope of tampering inflation without further harming the banking system. The raise marks the 9th consecutive rate hike since the Fed began hiking in May of last year and brings the target fed funds rate range to the highest level since September 2007. While the central bank’s monetary policy has been aimed at correcting inflation, it has also revealed hidden weaknesses (e.g., entities whose balance sheets relied on low interest rates).

MBS Weekly Market Commentary Week Ending 3/17/23

Next week will reveal the Fed’s resolve on continuing to beat the drum on their aggressive inflation fight. The word until now has been that the central bank will keep hiking interest rates until inflation is under control.

MBS Weekly Market Commentary Week Ending 3/10/23

Events this week likely will lead to a higher peak interest rate than investors had been expecting just weeks ago. Central bankers appear worried about a cycle in which workers seek higher pay to offset inflation’s bite, and in turn trigger more price increases. In fact, inflation remains high because people have jobs and earn enough income to cover stubbornly expensive housing costs. Robust hiring is good for the economy and workers, but elevated pay growth puts added pressure on the Fed to bring down earnings. 

MBS Weekly Market Commentary Week Ending 2/10/23

The week after the jobs report is generally pretty data-light, and this week was no exception. With a dearth of data, market movement hinged on “Fed speak” and consumer sentiment. We saw some volatility return to bond markets as investors built in expectations for a more hawkish Fed. As a reminder, the Fed raised its benchmark rate last week to a range of 4.5% to 4.75%. Let’s run through what we’ve learned in the wake of that decision and a robust U.S. payrolls report that took some wind out of investors’ sails that had hopes for rate cuts by summer.

MBS Weekly Market Commentary Week Ending 2/3/23

As strong as economists may have thought the job market was, it’s even stronger. In addition to headline non-farm payrolls in January (517,000) beating estimates by around 300,000, employment numbers were revised higher for the past two months. Yes, a tight labor market is anathema to any sort of quick stop to the Federal Reserve’s rate hiking cycle, but the growth rate in average hourly earnings is declining, which will be welcome news to Fed Chair Powell and his colleagues. There exists a raging debate among economists over whether we’ll need a sharp rise in unemployment to keep inflation low.