 |
| John Dolan |
Dolan is chief investment officer responsible for $12 billion in fixed income in New York. He also monitors various portfolio management and product trading areas.
How do you respond to the 25 basis point rate hike?
This is one of the most expected and well-telegraphed rate increases in recent Fed history. The Federal Reserve officials talked about deflationary fears and non-traditional ways of dealing with rate curve management that put a kind of scare into the market and brought the 10-year rate down to the 3% range last spring. They were accused of not being clear in their intention to the bond markets. This caused damage to the markets. This time around it was overly clear that the response will be in measured terms. They did a good job of telegraphing their intention to raise 25 basis points this time and 25bps next time. The Fed is determined to raise rates in an orderly fashion to prevent any shock to the system.
How does this affect the mortgage-backed securities market?
As a MBS portfolio manager, this kind of clear signal about the direction of interest rates contributes to a decline in volatility. This definite signal has contributed to the current low volatility and this is good for the mortgage-backed securities market in terms of their negative convexity and embedded call on extension options. We have been in and will remain in a stable rate environment for the MBS sector.
How would you describe the relevance and significance of volatility in the mortgage-backed securities market?
If volatility increases, MBS spreads widen and it becomes attractive as an investment. But the dilemma today in buying MBS is while it is a great environment; this stable environment is priced in to the current levels. One has to believe that this environment is likely to be maintained in the coming months. This is likely to continue in my view. We are concerned by external shocks to the system such as oil, inflation and geopolitical developments, especially as we go through the Republican convention or elections. Absent geopolitical concerns, there is nothing on the horizon that indicates volatility is likely to pick up in the near future.
How do you explain the increase in supply of high-coupon MBS lately?
When mortgage bankers have production to hedge and they expect applications to slow, which is especially the case when rates rise, they tend to sell whatever applications they get. They sell MBS to hedge against new mortgages. This is typical of the originators. This is more so when they do not want to be caught with an unexpected rise in rates.
How was all the extra supply absorbed?
The agency markets are incredibly deep and resilient and have the ability to absorb an extra $1 billion or $2 billion or $3 billion in supply without prices moving in any material way. This increase in volume tightened the market marginally, if at all. Consider that 6s represent probably one of the more negatively convex components of the MBS index and the demand for these reflect the view that volatility will continue to come down and that coupon will outperform the MBS index.
What do you expect to see in the MBS market in weeks ahead?
Now that the decision is behind us, the fixed-income strategists will meet to look at the different sectors and will conclude that the 6% coupon range looks attractive, relative to corporate spreads. I will not be surprised if there is a renewed interest in the 6% coupon range in July.
Since the rate increase has been on expected lines, there is no tail risk. They can invest in the current environment. The long end is appropriately priced at this point and the front end will be a function of the Fed Funds rate and the pace with which the Fed increases interest rates. Mortgages are going to be attractive relative to other sectors in this fairly benign environment.
Within the MBS sector, what particular product will be attractive besides the 6% coupons?
When rates rise and the curve flattens, the issuance of 15-year hybrid ARMs will probably decline. The high cost of hybrid ARMs in a rising-rate environment has been an excellent investment because the duration is short. I think a combination of declining supply and a bearish outlook among mortgage traders will keep the strong bid for the hybrid ARMs sector. The outlook will be bearish because the Fed has telegraphed a rise in rates for the remainder of the year.