The penultimate month of 2018 was a roller coaster for risk assets, as trade
tensions between the U.S. and China, a gamut of speculation about Federal Reserve
policy, and fear about Brexit kept market participants on high alert. Agency MBS
performance ultimately ended the month quietly, but not before vacillating wildly
week to week in November. After a late October swoon of risk assets caused by
Federal Reserve Chairman Powell striking a hawkish tone in the face of global
economic and trade uncertainties, the start of November provided the markets with
some much needed relief. U.S. elections turned out largely as expected, momentarily
reducing volatility and pulling agency MBS relative performance into positive territory.
Interest rates inched higher, as markets returned to normalcy for a fleeting moment,
yet tension and fear returned just as quickly as they had dissipated. Concern
over the UK’s attempt to leave the EU created broad consternation in global risk
markets. Furthermore, escalating trade tensions between the U.S. and China further
broadened trepidation. Interest rate volatility rose right back to month end levels,
sending the agency MBS basis wider once again. After the Thanksgiving holiday, the
Federal Reserve struck a more dovish note, while optimism built that the U.S. and
China might be able to resolve escalating tariffs and calm rhetoric around trade. The
change in tone allowed agency MBS valuations to rally back at the close of the month.
Ultimately, risk markets closed close to where they had opened November, while U.S.
Treasury yields fell slightly, providing the backdrop to an unchanged month. The path
was neither smooth nor easy. In total, the Bloomberg Barclays MBS Index posted
excess returns of zero basis points (bps) in November, leaving agency MBS relative
performance unchanged at negative 43 bps year to date. A positive month of 90 bps
for total returns still left year to date total returns at negative 81 bps.
Intra coupon stack was relatively quiet over the month. The slight decline in yields did
little to shuffle coupon stack performance despite the month’s choppiness. Fannie
Mae 30yr (FNCL) 3s and 4.5s were both negative on the month, coming in at -1 bp
and -11 bps respectively. The slightly worse performance in higher coupon MBS makes sense in the context of falling interest rates during
the month, while the ever so slight underperformance of
FNCL 3s relative to U.S. Treasuries was notable as a lower
coupon that ordinarily would benefit from a lower interest
rate environment. FNCL 3s remain well below par and thus
have no production, limiting their buyer base and keeping
the coupon from outperforming despite fully extended
durations and the momentum toward ever higher interest
rates halting for the moment. Meanwhile higher coupons held
in potentially better than expected in a falling interest rate
environment behind better carry and continuing production.
In Ginnie Mae collateral, performance differences were
starker. Ginnie Mae 30yr (G2SF) 3s and 3.5s came in at
-10 bps and -4 bps respectively relative to benchmark U.S.
Treasuries. This underperformance has been present most
of 2018, with year to date excess returns sitting at -69 bps
for G2SF 3s and -1.01% for G2SF 3.5s. An increase in the
regulation of banks has propped up Ginnie Mae collateral for
much of the post-crisis period. The reversal of some of these
regulatory actions has taken a toll on the collateral this year,
limiting the buyer base and putting tremendous pressure on
lower coupon Ginnie Mae collateral. Higher coupon Ginnie
Mae collateral has not been subject to the same sort of
pressures as it has been bolstered by reduced speeds, the
result of legislative action to temper the severe loan churning
activities that plagued the market in years prior. Ultimately,
with one month until the end of the year, the challenges to
lower coupon Ginnie Mae collateral have yet to abate, and
show no signs of slowing despite falling interest rates.
Each November the Federal Housing Finance Administration
sets limits on the maximum allowable loan size for a loan to
be eligible for placement into agency MBS securities. Starting
in 2008, a law was passed that set the maximum limit at $417k
for a single-family mortgage with loans in the more expensive
areas in the country allowed at up to 150% of the maximum.
These limits were not permitted to rise so long as housing
prices remained below their pre-crisis peak. The limits were
stable until 2016, when housing prices finally rose to pre-crisis
levels, allowing the FHFA to raise the maximum loan size,
based on the level of home price appreciation in the previous
year. This year the FHFA determined that housing rose a
strong 6.9% in 2017, raising the maximum limit to $484,350
for most Americans and $726,525 in high cost areas. These
increases are significant since higher loan balance pools tend
to be more sensitive to prepayment incentives than lower
loan balance pools. Thus, the run-up in conforming loan sizes
might make pools that are issued in 2019 more sensitive to
changes in mortgage rates than new production pools in
previous years. Furthermore, this sharp rise in conforming
loan limits comes just as evidence begins to gather that the
pace of home price appreciation is slowing. With 2019 right
around the corner, increasing loan sizes in agency MBS pools
just as housing might be cresting is an important trend to
watch, especially given the rising economic uncertainty and the
presently minimal prepayment risk in the market.
The year thus far in agency MBS has seen negative total
and relative performance. Higher rates, rising volatility, and
concern over the Federal Reserve balance sheet unwind have
pressured mortgage spreads wider and damaged valuations.
Agency MBS yields relative to U.S. Treasuries have widened
out despite very low prepayment risk and volatility that
remains below historic norms. This makes it appear that
agency MBS valuations are more attractive than before this
market turmoil. While it is widely expected that volatility will
pick up as the Federal Reserve continues to hike interest rates
and let the balance sheet wind down, the uptick in volatility
thus far has been relatively modest. While past performance
says nothing about future results, it is always possible that
volatility could remain low into the near future. However,
caution is always warranted. The roiling of emerging markets,
continuing trade tensions, and the potential for slowing
economic growth pose significant risks for markets moving
forward into the final month of 2018 and the year beyond.
The guaranteed principal component provides agency MBS
a bulwark against market downturns, and means mortgages
will remain a vital piece of fixed income portfolio construction
despite rising risks in markets around the world.
