MBS Weekly Market Commentary Week Ending 3/29/19

Treasury yields declined on the week, leaving the 10-year yield at its lowest level since December 2017.

*The MBS Weekly Market Profile Report corresponds to the commentary below.*

The belly of the curve underperformed, as the 2-year note and 30-year bond both had the best weekly performance. This left the yield curve steeper (or less inverted), as the 2-10 year spread widened by 2 basis points while the 2-5 year spread widened by about 5 basis points, although it remained slightly inverted at -3 bps.

Mortgages widened versus Treasuries last week, with the Fannie 30-year current coupon spread over interpolated Treasuries widening by about 3 basis points. Most of the market’s price relationships remained stable, with almost all coupon swaps ending the week within a tick of the prior week’s closing levels. One noteworthy development was the strengthening in 30-year 3% rolls, which left the April/May Fannie 3 roll trading almost 2+ special. The improved roll in part reflects the sharp pickup in trading in Fannie 3s in March. According to TRACE data, average daily volumes in Fannie 3s more than doubled from $9.7 billion in February to $23.1 billion in March, and were over $36 billion from March 21st (the day after the Fed meeting) through 3/29. (For context, volumes in Fannie 3.5s increased to $48.8 billion from $41.8 billion and for Fannie 4s from $52.8 billion to $64.9 billion.)

A key question being asked is whether the current low level of Treasury yields is sustainable and reflects fundamental economic conditions. (Mortgage originators are especially interested in whether the bond markets can consolidate around current levels, as mortgage rates ended the week below 4.10%; as we wrote in our 2019 Forecast, mortgage rates below 4% will probably be necessary to trigger a renewed round of refinancings.)

However, a story in Bloomberg cast doubt on the sustainability of the rally, pointing out that tightening swap spreads suggest that some of the demand was due to “convexity buying,” or purchases of assets by investors to offset the shortening durations of their mortgage portfolios. A few calculations suggest that investors may have been engaged in such portfolio rebalancing which, in volatile markets, causes Treasury yields to overshoot their economic value. For example, we can estimate how much exposure the markets “lost” by converting the changes in MBS durations and hedge ratios (relative to Treasuries) into “treasury equivalents.” These is calculated by taking each coupon’s outstanding balance at a point in time and multiplying the balances by their hedge ratios on different dates, and then comparing the results.

The shorter MBS durations that resulted from the rally did affect a material shortening of the MBS market’s exposures. For example, the exposure of the agency 30-year MBS universe (which totaled roughly $3.4 trillion in outstanding balances at the end of February) decreased by the equivalent of just under $300 billion in 10-years between March 1st and 27th. On its face, this suggests that MBS holders needed to buy substantial amounts of Treasuries from other investors to maintain their exposures.

However, there are additional considerations that modify this notion a bit. For one thing, quarter-end buying was probably a factor in last week’s rally, which also explains today’s sharp selloff. In addition, not all investors adjust their portfolios to reflect duration targets; these activities are generally the province of REITs and money managers that track a market index or benchmark. Moreover, the largest single holder of MBS is the Federal Reserve, a passive investor that does not match a benchmark and hasn’t done an MBS trade since October. If you remove the Fed’s holdings from the calculations, the rally reduced the market’s overall exposure by around $210 billion 10-year equivalents last month. Since only a subset of remaining investors actually will adjust their portfolios to reflect changing durations, the overall decrease in exposures was not enough to pressure yields lower by more than a few basis points for a short period of time.

About the Author: Bill Berliner

As Director of Analytics, Bill Berliner is tasked with developing new products and services, enhancing existing solutions, and helping to expand MCT’s footprint as the preeminent industry-leader in secondary marketing capabilities for lenders.

Mr. Berliner boasts more than 30 years of experience in a variety of areas within secondary marketing. He is a seasoned financial professional with extensive knowledge working with fixed income trading and structuring, research and analysis, risk management, and esoteric asset valuation.

Mr. Berliner has also written extensively on mortgages, MBS, and the capital markets. He is the co-author, with Frank Fabozzi and Anand Bhattacharya, of Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques, which was named one of the top ten finance texts in 2007 by RiskBooks. He wrote and edited chapters for The Handbook of Mortgage-Backed Securities, The Handbook of Fixed-Income Securities, Securities Finance, and The Encyclopedia of Financial Models. In addition, Mr. Berliner co-authored papers published in The Journal of Structured Finance and American Securitization. He also wrote the monthly “In My View” column for Asset Securitization Report from 2008-2012.