March Agency MBS Market Update

Monthly Commentary

April 04, 2017

The agency MBS basis was close to unchanged in March, despite a strong month for risk assets and a late rally in government bonds. Economic data at the beginning of the month came in above expectations, with non-farm payrolls up +235k, leading market participants to anticipate a Federal Reserve hike at their March meeting. The spread between mortgages and Treasuries widened as market participants reflected on the possibility that the Fed might choose to accelerate the wind down of their principal reinvestments in agency MBS. U.S. Treasuries also sold off, sending the yield on the 10yr U.S. Treasury back to the highest levels seen since 2014 (2.62%) during the first half of March. The jitters continued into the FOMC meeting where the committee did in fact raise interest rates for the first time this year, marking the second hike in the last four months, the first time two hikes have occurred in such close succession since 2006. The market abruptly reversed course as the interest rate hike was announced, putting risk assets under pressure while U.S. Treasuries rallied sharply. The agency MBS basis began to tighten during Chair Yellen’s press conference. Asked about the possibility for the Fed tapering reinvestments of agency MBS holding, she replied, “I think the right way to look at it is in qualitative and not quantitative terms. It doesn’t mean some particular cutoff level for the federal funds rate that when we have reached that level, we would consider ourselves well under way.” The quote registered as dovish with market participants, due to the existing expectation that the Fed will wind down extraordinary monetary measures from the post-crisis period soon after interest rates rise above 1%. Yellen’s focus on qualitative rather than quantitative terms provides the Fed with more latitude should they choose to extend reinvestments for a longer period of time. The dovish tone caused the agency MBS basis to rally in the latter half of March. Treasuries also snapped back to their month opening levels (10yr at 2.39%). The end result was monthly performance in mortgages that finished slightly positive in March after a wild ride. In aggregate, the Bloomberg Barclays MBS Index posted excess returns relative to U.S. Treasuries of positive four basis points (bps) in March, bringing year to date excess performance to -17bps.

The relatively benign overall valuation picture did not prevent notable shifts in coupon stack performance. In 30yr collateral, lower coupons outperformed their higher coupon counterparts, with Fannie Mae 30yr (FNCL) 3s finishing with 10bps of excess returns while FNCL 4.5s ended up at -3bps relative to U.S. Treasury hedge ratios (HRs). Given the somewhat pervasive viewpoint that interest rates are likely to increase going forward, lower coupons struggled the past couple of months due to extension risk. The late month rate rally was beneficial to holding off headwinds to lower coupon MBS. Despite the weak month in higher coupons, overall excess performance in FNCL collateral was positive 6bps in March, which significantly outpaced Ginnie Mae collateral. 30yr Ginnie Mae (G2SF) struggled across most of the coupon stack, which is notable for a couple of reasons. The first being that G2/FN swaps often appreciate as rates rise, due to a generally faster prepaying cohort of borrowers. In March G2/FN swaps moved in reverse of this trend, falling as rates rose in the first half of the month, before rallying back in the back half of March. There are two potential reasons for this. The first cause was a notable lack of demand from foreign buyers in March as Japan approached their fiscal year end, which would be likely to correct quickly heading to next month. Furthermore, there is some evidence that G2/FN swaps have been moving in concert with the basis more in recent months, which will be a trend to watch going forward to see if it will hold. Given the recent weakness in TBA roll levels, and the overall challenge of a less involved Federal Reserve, coupon stack positioning and pool selection will be increasingly paramount to overall performance going forward.

One facet of the overall picture in agency mortgages that remains constructive is the low overall level of prepayments. Higher interest rates have persisted since the November election and have greatly reduced the risk of elevated prepayments. A slower than expected prepayment report released at the beginning of the month bolstered the prevailing narrative. To wit, speeds in February dropped 20%, with FNCL collateral dropping from 11CPR to 8.8CPR. Prepayments fell across the coupon stack with FNCL 3.5s-4.5s falling over 20%. 5% of the drop can be attributed to a lower day count in the short month of February. Speeds still fell slightly more than expected bringing them to their recent lows. 15yr collateral fell 15%, while Ginnie Mae prepayments dropped 10%, aiding G2SF collateral. Mortgage rates have been stagnant since the end of 2016 backup, staying in a 17bps range between 4.29% and 4.46% since December of 2016. The stagnant but elevated mortgage environment has left only a small fraction of borrowers in position to refinance their homes. So long as this persists, it is unlikely that prepayments will rise significantly near term, outside of near term adjustments for seasonal factors and day count.

The regulatory news is beginning to ramp back up after a relatively quiet period early this year. The most notable announcement in March was a delay to the implementation of Single Security. Single Security is a plan conceived by the Federal Housing Finance Administration (FHFA) to increase liquidity in the agency MBS market by making the securities of both Freddie Mac and Fannie Mae exchangeable into one single security. The effort has had numerous delays thanks to the complications of getting the system set up operationally, as well as the challenges of getting both agencies to fully buy into the process. The previous update from the FHFA suggested that the security would be operational by late 2018. The newest update delayed implementation for another six months until the second quarter of 2019. The most obvious overall market impact of single security implementation is that the spread between Fannie Mae and Freddie Mac backed collateral should converge toward zero, however secondary impacts are less certain. In particular, how much liquidity will or will not improve with just one type of TBA is very much unknown. Furthermore, how the deliverable in each coupon will be affected by the change will have to be worked out, if and when the process is complete. For now, the market remains largely unaffected by single security updates, however that is likely to change as implementation gets closer and the end game comes to fruition.


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