May Agency MBS Market Update

Monthly Commentary

June 01, 2017

Tailwinds prevailed in May, as the lack of negative headlines and persistently low volatility drove agency MBS valuations back to even, relative to U.S. Treasuries for 2017. At the beginning of the month, a small amount of headline risk remained from the election in France. Fear of a win by anti-EU candidate Marine Le Pen had riled markets in April, yet in May she was unable to get within striking distance of Emmanuel Macron in the run-off. The election result caused volatility to drop, setting the tone for the remainder of the month. The non-farm payroll print came in slightly above expectations (+211 k versus 190 k expected), and largely stable mortgage rates buoyed agency MBS valuations. The slight uptick in interest rates early in May reversed as the month wore on, largely the result of policy risk in Washington DC. Fear that expected fiscal reforms under the new president might not materialize has weighed on long-term interest rates, even as the Federal Reserve appears ready to further hike short term rates. The opposing directions of the paths of long and short interest rates is part of an eerie calm that has settled over global markets. In the second half of May, volatility hit a new three year low, doubly impressive given already subdued volatility in the market over much of the post-crisis period. The drop in realized volatility, while concerning to those waiting for a storm to break out, was beneficial to agency MBS valuations. Levels were buoyed meaningfully by the lack of shocks in interest rates, as agency MBS performance relative to U.S. Treasuries briefly turned positive for the first time in 2017 before dropping back. In aggregate, the Bloomberg Barclays MBS Index outperformed benchmark U.S. Treasuries by 14 basis points (bps) in May, bringing 2017 excess performance to zero bps for the year.

Lower coupons led the outperformance within the agency MBS coupon stack in May. Fannie Mae 30yr (FNCL) 3s led the charge, finishing with excess returns of 23bps relative to U.S. Treasuries. FNCL 3.5s and 4s also broke into positive territory for the year, posting excess returns of 15bps and 13bps, respectively. Mortgage rates dropped to their lowest level of 2017, benefiting lower coupon MBS more than higher coupon mortgages. The story was the same in Ginnie Mae (G2SF) collateral, as G2SF 3s posted excess returns of 25bps, with G2SF 3.5s coming in up 18bps during the month. In both Ginnie Mae and FNCL collateral, the performance of lower coupon issues has been highly interest rate path dependent in 2017. This dependence could hinder their further outperformance should interest rates move up in the second half of the year. The tailwind of lower volatility has been more uniform, benefitting both high and low coupons alike. The reduction in volatility, both implied and realized, has caused option adjusted spreads (OAS) to widen, even while yield spreads have held firm. The divergence between these two indicators is somewhat uncommon, and suggests that agency MBS investors ought to exercise caution when looking at key valuation metrics. Due to the old adage that, ‘you can’t eat OAS’, it is likely that ever-tightening spreads versus U.S. Treasury yields are the more important metric to use in the current environment. Given tight yield-based valuations, finding stories that retain room for outperformance in the face of potential increasing interest rates and volatility remains an important focus for market participants.

Prepayments in April remained muted, the result of mortgage rates that have stagnated in 2017. Speeds fell 8%, largely the result of a lower day count. Prepayments were slightly lower than estimates, as turnover decreased slightly in lower coupon MBS. Aggregate speeds fell more in higher coupons, helping to close the gap with lower coupon outperformance. FNCL 4s fell 11%, while FNCL 4.5s dropped 9%, a much higher percentage than FNCL 3s which dropped a mere 3%. Slower than expected prints in higher coupon agency MBS provided relief to cohorts that have been under some pressure in recent months. Another notable element of the April report was prepayments on Freddie Mac 30yr (FGLMC) collateral dropping less than FNCL collateral. The two GSEs’ collateral prepayment paths had diverged in March as FGLMC collateral speeds dropped more swiftly than their FNCL counterparts. Getting the two GSEs’ speeds in line with one another has been a goal of regulators who hope to institute a single security that is cross-guaranteed by both GSEs in the next couple years. The deviation in prepayments that occurred in March was a mildly bad sign for that goal, as it would be more problematic to cross guarantee securities with dissimilar prepayment patterns. Speeds converging in April are a positive signal that it might be possible to keep prepayments in line on a go forward basis.

Federal Reserve minutes released in May finally telegraphed to the market how the FOMC will handle balance sheet reduction. Once the Fed chooses to begin to taper reinvestments, the FOMC will announce limits to the amount of assets that can roll off the balance sheet without being reinvested each month. According to the minutes, the caps will go up every three months, allowing the balance sheet to slowly drift toward the FOMC’s desired level. The announcement clears some of the fog from the market with respect to future Fed policy, although the speed and timing of reductions remains uncertain. GSE reform was another major topic of regulatory discussion in the agency MBS universe this month, as regulators look to address the upcoming challenges for Fannie Mae and Freddie Mac with respect to capital requirements. Specifically, as the rest of the financial system has recapitalized in the aftermath of the financial crisis, both Freddie Mac and Fannie Mae are restricted, having signed agreements with the U.S. Treasury in 2012 requiring them to hold no capital beginning in 2018. Due to the fact that both GSEs remit all their earnings to the U.S. Treasury, the two entities would not have any capital to draw from should they suffer a quarter with negative earnings. The issue is a significant one, although probably not because it would cause a credit event. In the event of a losing quarter, it is highly probable that the GSEs could draw funds from the U.S. Treasury despite retaining no capital, however the political optics would likely be exceedingly problematic. The appearance of a bailout would embolden calls for privatization of the two GSEs, as they would be drawing from the coffers of the taxpayers. This could complicate efforts for GSE reform, which will ultimately need to be undertaken by Congress. The issue is also made more complicated by the fact that, despite both GSEs being profitable, accounting and hedging constraints leave both vulnerable to quarterly losses when interest rates fluctuate. Therefore it is probably only a matter of time until a losing quarter and a draw from U.S. Treasury funds. Solutions are hard to come by, as the Secretary of the Treasury has stated he expects the GSEs to forward earnings to the Treasury as agreed upon. Should that stance stay firm, GSE reform might end up walking a very thin line in the coming year.

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