FLASH UPDATE: Recent Events Highlight the Benefits of a Liquid Mortgage Relative Value Strategy in a Rising Rate Environment

Recent Events Highlight the Benefits of a Liquid Mortgage Relative Value Strategy in a Rising Rate Environment

A liquid mortgage relative value strategy seeks to capture the yield advantage of government guaranteed MBS over Treasury securities utilizing the highly liquid mortgage TBA market.  This strategy has historically exhibited a high Sharpe Ratio across market cycles; however it is particularly well suited to perform well in a rising interest rate environment.  Events over the past year, and in particular since the Fed’s March 19^th meeting this year, provide a perfect environment to evaluate the efficacy of this assertion.

In the 2^nd quarter 2013, Chairman Bernanke suggested that the Fed’s QE program might begin to taper near the end of 2013 and stop altogether sometime near the conclusion of 2014.  Treasury rates have risen about +100 bps since that time – perhaps a perfect starting point to evaluate the assertion discussed above. 

However, the initial reaction of the mortgage market was for mortgage spreads to actually widen.  In fact they continued to widen until December 2013 when the Fed announced that it would immediately commence tapering its asset purchases in a measured and methodical manner.  Clearly, this departure from historical behavior was caused by the markets awaiting clarity as to the actual timing and trajectory of the Fed’s upcoming Taper program.  Once the Fed provided that clarity in December 2013, mortgage spreads have consistently tightened since that time and are now approaching the spread levels last seen in April 2013.  We suspect there continues to be room for additional tightening as rates are expected to continue to rise and Tapering continues on its glide path to completion.  We can look to more recent events to provide additional evidence of this.

On March 19^th of this year, the Fed dropped its explicit unemployment target, broadened its discretion for when it may begin to raise rates and bumped its economic projections higher.  Taken together this was viewed as a more hawkish tone than previous language.  And as a result, Treasury rates rose +20 bps on the day and mortgage spreads did indeed tighten +7bps; both strong moves. 

Conversely, on April 9^th the Fed minutes to this same meeting were released, downplaying the hawkish tone to the onset of future rate hikes.  Treasury yields dropped -5 bps on the day and mortgage spreads tightened -4 bps as well.

In summary, our April 14^th column discussed how a Liquid Mortgage Relative Value Strategy has responded well to rising rate environments over the past 30 years.  Recent events provide additional anecdotal evidence of this.  In future columns, we will evaluate other attractive characteristics of this strategy, such as its low correlation to equity, bond and commodity markets.

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global