FLASH UPDATE: TRV Weekly Commentary - Rate & Refi Volatility

TRV Weekly Commentary
Week Ending 19 Nov 2014

Comment:

The 10/5 spread compressed to 71 bps this week as rates bull-flattened. We attribute half of the 6 bps decline to Japan’s poor 3Q GDP print. On an annualized basis, Japan’s economy contracted 1.6%, a stark contrast to expectations, a 2.2% expansion. This data point shocked Japanese equities, with the Nikkei falling 3% . The US bond market reaction was more muted, although implied swaption vol ticked up 2 bps. We do anticipate that the unexpected contraction of the third largest economy will have had a meaningful impact on US output.

Assuming Japan’s recession has a material impact on US growth, we would expect rates to rally and spread products, such as mortgages, to lag. For now, the basis continues to outperform its Tsy hedges as down-in-coupon MBS outperformed the 5yr by 8-10 ticks. We retain a neutral to bearish view on the basis as the yield spread between the current coupon and the 5yr is 1.89 standard deviations below its mean, origination remains strong, and the Fed has finished growing its balance sheet.[1]

Notwithstanding the fall in Treasury and primary mortgage rates, the refi index fell 17 points. While this seems counterintuitive, consider that the average 30-year mortgage rate reached a low of 3.93 only one month ago. Two important mortgage concepts come into play, seasonality and the refi ‘elbow’:

§  Seasonality has a large impact on turnover in the housing market. The housing market, in terms of existing home sales, tends to pick up in the spring, reach its peak in the summer, and decline through the winter as shown in the Prepayment Seasonality chart. When a homeowner sells a house, the existing mortgage principal is paid off in full upfront, just as it happens in the case of a homeowner refinancing his loan. As we enter the winter months, prepayments will likely decrease absent a large movement in rates or a new government program.

§  The refi elbow, on the other hand, refers to the homeowner’s incentive to refi at prevailing rates. If the rate incentive were only 5 bps, we would expect minimal refi activity. However, if the rate incentive increased to 25 bps, we would expect refi activity to pick up. The Refi Elbow chart illustrates the impact of shifting the ‘elbow’ 50 basis points, thus adding 50 basis points to refi incentive. As incentive increases, we see the one-year CPR for a FNMA 3.5 TBA increase. The term ‘elbow’ comes from the shape of the curve, which loosely resembles an elbow.

Considering these concepts, it's no surprise that the refi index fell this week: seasonal impacts likely overcame the minimal shift in rates. We hope this illustration informs the reader of a portion of the anatomy of prepayments.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

Prepayment Seasonality

Refi Elbow

Mortgage Basis Data

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[1] We estimate the basis as the difference between the price of Bloomberg’s MTGEFNCL Index and the yield of a generic 5yr Treasury. The data show daily spread levels between 11/21/2007 and 11/19/2014. See the chart at the end of this document for more information.