April Agency MBS Market Update

Monthly Commentary

May 03, 2017

A late month surge caused Agency MBS to finish in positive territory in April, as Federal Reserve policy risk and negative macro headlines were overcome by a reduction in implied volatility. Global markets in April mostly focused on headline risks, with the Federal Reserve, the French election, and the ongoing policy battles in Washington D.C. occupying most of the available oxygen. The first shoe to drop in April for agency MBS investors was the publication of the Federal Reserve minutes. During their March meeting, officials discussed the fate of their current holdings of agency MBS securities and U.S. Treasuries. The market interpreted that the Fed is likely to reduce its mortgage holdings sooner but more gradually than anticipated. The agency MBS basis reacted tepidly to the news, as the devil remains very much in the details as to the manner and timing of FOMC policy changes. Global markets quickly pivoted to the specter of the French election. Market participants feared that the election could have a similar fallout to ‘Brexit’ which occurred last summer. A win by National Front candidate Marine Le Pen could lead to France following Great Britain out of the European Union. Risk assets sold off, and the 10yr U.S. Treasury yield dropped from 2.42% down to 2.17% heading into the election. The rise in anxiety was negative for the agency MBS basis, as the possibility of rising prepayments returned to the periphery for investors. The positive side was a simultaneous drop in the probability of the FOMC quickly ending their extraordinary monetary measures that have been in place since the crisis. Market fear was allayed somewhat by the results of the first round of the voting, Le Pen finishing in second place to a more moderate candidate, who will enter the run-off with a considerable lead in the polls. The result was a strong push for risk assets and agency MBS. The confluence of reduced volatility, a partial reversal of the U.S. Treasury yield decline, and a positive environment for risk pushed the agency MBS basis ever so slightly into positive territory for April. In aggregate, the Bloomberg Barclays MBS Index posted excess returns of positive 2 basis points (bps) relative to U.S. Treasuries in April, bringing year to date excess returns to negative 14bps.

The election last November and the subsequent interest rate selloff have had lingering effects on the coupon stack and relative performance across the agency MBS universe. While the coupon that has been hit the hardest in the post-election downturn is the Fannie Mae 30yr (FNCL) 4.5, the FNCL 3 had the most notable performance in April. One of the challenges that are particular to FNCL 3s is that the sharp rise in mortgage rates not only lowered prepayments as it did in all coupons, but also made FNCL 3s a discount coupon. While not a disaster in and of itself for investors in FNCL 3 collateral, the potential for serially higher interest rates in the future paints a dark picture. If positive economic growth or a liquidity crunch were to force the term structure of interest rates materially higher on a go-forward basis, there is a non-zero risk that FNCL 3s could become an orphan coupon. Materially higher mortgage rates that stuck would not only cause conventional 3s, which comprise around 15% of the Bloomberg Barclays MBS Index, to trade at a discount, but also leave them with extended durations and almost no new issuance. The rally in the 30yr mortgage rate from 4.34% to 4.20% helped mitigate the orphan coupon concern in April, with FNCL 3s providing 20bps in excess performance relative to U.S. Treasuries in April. The rest of the coupon stack also performed favorably, with FNCL 3.5s ending up 6bps, and FNCL 4.5 posting 16bps of excess returns. Positive conventional collateral performance was not mimicked in Ginnie Mae 30yr (G2SF) MBS. Rough sledding in March spilled over into April, with lower mortgage rates and continued lack of sponsorship pushing G2SF valuations wider. The poor performance of Ginnie Mae MBS left aggregate performance close to flat despite the positive returns in conventional collateral.

Prepayments were far more benign than headline numbers suggested for April. FNCL collateral posted speeds that were 23% faster in March than in February, which on the surface suggests some potential concerns. The increase in day count was responsible for almost the entirety of the increase. Furthermore, it was the first prepayment spike in six months, meaning that the increase is coming off of a very low base. Speeds were slightly slower than many market participants anticipated, leaving the overall prepayment picture somewhat clear for the time being. Within the coupon stack, lower coupons paid faster than higher coupons on a percentage basis, with FNCL 3s jumping 43%, and FNCL 4.5s jumping a mere 11%, providing a tailwind to the positive month for FNCL 4.5. The decline in mortgage rates of 14bps over the month may cause a mild prepayment jump in the summer, and will force investors to monitor mortgage rates in case further rate decreases lead to faster speeds. For now, the lion’s share of the MBS universe remains unlikely to be refinanced, and so long as that condition persists, agency MBS prepayments are likely to remain lower than they were in 2016.

The major regulatory event in April was the release of the FOMC minutes of their meeting in March. The market has been awaiting information about the Fed’s eventual exit strategy for years; nearly the length of time the Fed has had $1.77 trillion in agency MBS holdings, and $4.25 trillion in total assets. Details have remained scarce, primarily because the Fed has not managed to form a clear picture internally on what the best method or strategy for unwinding their balance sheet might be. As the unemployment rate continues to decline and the Fed seeks to normalize their operations, the meeting minutes are the closest the market has come to understanding the Federal Reserve’s thought process about balance sheet reduction. One major nugget of information the minutes mention is that members judged, “a change to the Committee’s reinvestment policy would likely be appropriate later this year.” The exact pace of balance sheet reduction has not been decided upon, but despite one committee member mentioning a pace that could include sales of current holdings of MBS, the most likely scenario would involve letting prepayments of principal provide the entirety of agency MBS balance sheet reduction. An earlier start to tapering can be viewed as a negative for agency MBS basis performance. More notably, the committee seemed inclined to include U.S. Treasuries as a part of reducing their balance sheet. This development was surprising both because the U.S. Treasuries the Fed has purchased have been removed from the Bloomberg Barclays Aggregate Index, and because it is believed that the Fed ultimately prefers to hold only U.S. Treasuries, which would have made the Fed more likely to taper agency MBS holdings prior to any U.S. Treasury reduction. The addition of U.S. Treasuries to the taper schedule would be notably positive for agency MBS investors, as it would delay the overall timeline until the Fed is no longer supportive of the U.S. mortgage market. While the minutes provided a window into the thinking of Fed officials, most of the market movement will be determined by the decision they ultimately come to, and their ability and willingness to stick with their plan in the face of whatever curveballs global markets throw between now and then.


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