Agency MBS Liquidity
We still seem to be a ways off from the point an actual FOMC voter says “let’s wait and see” when it comes to hiking rates. Until that occurs, bond prices continue to fall and the Fed (and others) will continue to incur paper losses on massive bond holdings accumulated during pandemic rescue efforts.
Agency MBS (bonds backed by Fannie and Freddie loans) are commonly the first securities sold in the early stages of market downturns due to their high liquidity. Remember, the agency MBS market is the most liquid fixed income market in the U.S. after Treasuries. The yield that investors demand for these securities are the basic input to determine mortgage rates in general. Bond funds have seen outflows as the prevailing investor sentiment has been to sell what you can now. MBS spreads have widened as a result.
Widening MBS Spreads
The MBS spread is the difference in yield between a 10-year Treasury and corresponding MBS. Because agency MBS have no credit risk (they are guaranteed by the government), the widening is due to overall liquidity and volatility in the bond market. MBS spreads right now are wider than they were at the peak of the financial crisis in December 2008 and wider than they were at the start of the pandemic in 2020 when the MBS market froze and the mortgage REITs were bedeviled by margin calls.
Over the past 10 years, MBS spreads have averaged around 80 BPS, but are hovering around 190 bps recently.
Recently, the hiccup in the UK bond market was a big catalyst for the widening of MBS spreads. Ex-Prime Minister Truss proposed a tax cut plan that sent the country’s financial markets spiraling because investors feared it would drastically worsen inflation. She tried to abandon the plan, but could not undo the political damage that the proposal had done. Who knew that boosting economic growth, the goal of tax cuts, can actually worsen inflation?
Over the past 10 years, MBS spreads have averaged around 80 BPS, but are hovering around 190 BPS recently. Put another way, that 110 BPS difference means that if the 10-year yield stays the same, there is likely a built-in improvement in mortgage rates of 110 BPS. Yippee! That means we could see rates fall to the low 6% range over the next few months, even if the Fed continues raising rates and the 10-year yield stays put.
Managing Execution in Wider Markets
Can spreads go wider? Yes, however, this is an historically unprecedented market and fortunately these spikes don’t last very long. Currently, every country is facing the dilemma of how to blunt the impact of inflation without making inflation worse. Even as rates continue to rise, from the standpoint of MBS investors, a government-guaranteed 6% rate of return is pretty attractive, especially compared to investment-grade corporate bonds or junk bonds.
It’s important to manage your execution in wider markets. In Nashville, chatter revolved around both the high coupon TBA markets and the difficulty pricing rate sheets. We’re here to help. Ask your trader for daily high coupon pricing grids and let us manage your TBA orders after you set your price/execution level. Contraction risks in the economy have been raised by tightening financial conditions, persistent inflation, and expectations the Federal Reserve will continue with rate hikes. If the economy does enter a recession, we will see investors sell credit risk and put their money in Treasuries and MBS. It could be sooner than expected. Stay up to date on all the latest news and moves in the mortgage market by joining our newsletter.
