FLASH UPDATE: TRV Weekly Commentary - Rate Normalization?

TRV Weekly Commentary

Week Ending 18 Feb 2015

Comment:

We saw quite a bit of market activity this week pre and post FOMC minutes. The rates market continues to focus on the tone of the minutes to infer when a normalization cycle will commence. Investors and the sell-side community generally anticipate a summer rate hike that has caused the yield curve to flatten over the past year with higher short-term rates and a strong global relative value story on the US 10yr. The minutes this week, however, reflected that FOMC participants are inclined toward “keeping the federal funds rate at its effective lower bound for a longer time.” The dovish tone sent 10yr yields about 8 bps lower before ending the week 6 bps higher at 2.08%. Despite the action in the 10yr, the true story in rates is the 9 bps of yield curve steepening which is beneficial to the carry component of MBS.[1]

With 10yr yields backing up 6 bps, MBS outperformed the benchmark 3 ticks while slightly underperforming the swap curve. We are relatively neutral on the basis given our bullish stance on vol due to European headlines, low inflationary prices and increased uncertainty as to the timing of a rate normalization policy. If the curve reverses this week’s movement, we would anticipate down in coupon swaps to perform well and for specs to outperform TBAs on reignited refi fears and increased desirability of call protection.

That said, the refi index fell 16% this week to a point that lies 27% below January’s peak. Much of the decline is attributable to the bear steepening of the curve we have seen as of late. In addition, savvy borrowers have likely taken advantage of January’s sharp decline in mortgage rates, which should cause a decreasing rate of refi applications. The decline in the refi index and the bear steepening yield curve provided tailwinds to IOs this week. Benchmark IO 4s were particularly penalized in January’s rate rally and so we have seen this sector outperform other IO sectors. Vendor OAS shows this sector has tightened between 5 and 38 bps.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

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[1] A steeper yield curve implies higher mortgage rates in the future, thus reducing prepayment expectations. We ran a FN 3.5 TBA using a live swap curve at the current market price and obtained an OAS of -5 and a long-term CPR of 13. We then re-priced the same bond with a 50bp steepening scenario and calculated an OAS of -27 and a long-term CPR of 8 that coincides with a 50-80 bp higher MBS current coupon.