FLASH UPDATE: Mortgage Spread Drivers Historic and Current

Mortgage Spread Drivers Historic and Current

Has the 600 pound gorilla – the Fed – changed the rules of the game?

Broadly speaking, mortgage spreads tighten as rates rise and widen as they fall (see graph A).  This pattern exists because Agency Mortgages, with their government guarantee, offer a higher yielding alternative to Treasury securities.  As rates rise, investors tend to “reach for yield” to offset losses in other parts of their portfolios.  Stated differently, investors will increasingly prefer Agency Mortgages over Treasuries in a bearish market environment as the higher yield of mortgages will help buffer losses in a down market.

The other phenomenon that frequently impacts the mortgage basis is volatility: as volatility increases, mortgage spreads will widen and vice-versa (see graph B).  How does volatility play into mortgage valuations?  Mortgages are similar to Treasuries, except that an MBS investor is short an option.  In the case of MBS, the embedded option is the right to refinance, which is owned by the mortgagee.  The more volatile rates are, the more likely the mortgage is “in the money”, and the more valuable the option becomes.  Volatility will hence cause mortgage prices to decrease and spreads to increase.

Graph A

Graph B

How have these two truisms panned out as the Fed tapers its unprecedented asset purchase program?

When rates rose in the second half of 2013, mortgage spreads widened counterintuitively as investors preemptively priced in the Fed’s decision to taper its asset purchase program.  By year-end 2013, the rising rate/spread tightening phenomenon was restored to its traditional relationship.  Namely, as rates began to rise, spreads began to tighten.  It is clear that investors believe that Fed tapering will continue at a rate of $10 Bln per month, and will continue to completion near the end of 2014.  Going forward, as rates rise, we are constructive on the mortgage basis.

However, that is not the end of the story. The Fed still has a meaningful impact on market volatility, which will continue to impact mortgage spreads.  For example, recent Fed meeting Minutes attest to the Fed’s impact on rate volatility.  Both the March 18-19 Fed meeting Minutes released on April 9th caused significant volatility in the Treasury market.  The volatility stemmed from a change in the market’s expectations of forward guidance of an interest rate hike.  The Fed will continue to play a dominant role in driving market volatility for as long as the eye can see.

To summarize, we believe the data-driven Fed policy environment we live in today will continue to offer investment opportunities for astute investors, even long after the Fed ceases its unprecedented asset purchase program.

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global