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| Rob Bloemker |
Describe the mortgage-backed securities market today. It is well-bid with the selloff in rates. The fear of prepayments has subsided and implied volatility has fallen and mortgages had one of the best years ever. This has been since late April when the market started predicting that the Federal Reserve was going to raise rates. The market has been anticipating the move that we saw in the end of June. After the initial selloff in April when mortgages extended and people had problems with duration, markets stabilized and realized that mortgages are less dangerous and are discount securities. We saw a tremendous amount of buying of mortgages and selling of options. That combination drove the mortgage market and was one of the best periods for mortgages.
Are you surprised mortgages are rallying in a rising-rate environment?
That is the initial view. But in reality, rates are moving as expected and the market is not affected. For example, if the market expects a 25 basis point move and that happens, the longer rates may not move at all. If the 10-year rates are 4.5%, then the market is expecting the Fed Funds rate to be higher than it currently is. The shape of the forward curve is exactly what the market is predicting. If the Fed follows that path of the curve, 10-year rates may not change. The worry in mortgages is not so much that the market moves but an unexpected move that is greater or lesser than the market expectations. If rates back up exactly the way the forward curve is predicting, then mortgages will enjoy that.
What has been the dominant fear in the mortgage market?
The fear in the mortgage market has been that banks would sell off. This fear has been there for the last year or so. We saw significant selling last summer when we saw 10-year rates quickly falling. But since then banks have been buying more than selling mortgages. This is because the demand for C&I loans are low and the corporations are not leveraging to the degree that we were anticipating in this economic environment. We have not seen enough demand for C&I to cause banks to sell mortgages.
How do you describe the mortgage market's reaction to Federal Reserve Chairman Alan Greenspan's recent remarks to the House and Senate Committees?
His comments were soothing and his assertion that rates would move in a measured pace was a message to the market that what is priced into the forward curve is not unreasonable. We are comfortable with rates being stable. This makes mortgages attractive. Mortgages have been fairly stable with low volatility. We have been range-bound even though we had daily moves of 10 basis points. We have been in the 4.4%-4.8% range for a while now.
How do you expect the market to behave between now and the next Federal Open Market Committee meeting?
I believe the market will be range-bound unless something truly unexpected comes out of the economy or the FOMC meeting. But my fear about the range-bound mentality is that if we do rally by, say, 50 basis points from here, the mortgage market will become dangerous. Negative convexity will increase and we could see a repeat of what we saw a year ago when mortgage investors had to buy more bonds to hedge duration and also options to hedge the convexity. This could make the market more volatile. A 50bps rally is not anticipated by the market.
Where do you see opportunities in the MBS market?
We think that the opportunities within coupons and mortgage derivatives are lighter than they historically have been. Yet, we do prefer premium mortgages because of the attractive compensation for the prepayment risk associated with it. We like IOs for the same reason as the premium mortgages. We have a position in IOs to take advantage of the spreads. The adjustable-rate mortgages are mildly attractive but liquidity is difficult to maneuver and so is difficult to take advantage of them.
What broad trends do you see occurring in this market?
We have had a great performance and it will be hard to continue that. They are going to perform in line with expectations and will not offer tremendous returns. It could suffer if the market rallies beyond the current trading range. In these times of low volatility we see people stretching for returns. As a result, illiquid instruments and instruments that have greater risk associated with prepayments outperform in this market because they offer attractive compensation.