So Far This AM...
- MGs wife gets flat tire...MG must run to rescue.
- NIKKEI, HANG SENG, TOPIX, KOSPI, DAX, CAC all lower.
- Democratic Party takes control in Japan
- TSY futures higher overnight but lower since 8AM.
- Stock futures weaker
- NY Fed President Dudley, who has FOMC voting rights, says its too early to talk about an exit from MBS purchase program. Seemingly good news for mortgage market, yet yield spreds widened up. Further illustration that MBS market isnt paying much attention to these discussions. We know program will end eventually...the market doesnt care bc most accounts are trading "up in coupon" anyway.
- Mortgages basically flat....prices should tick higher but will be outperformed by benchmark big brother TSYs.
Recap of Last Week...
- Seasonal summer slowness
- Rates market choppy, but TSYs do "just fine" regardless of supply, 10 yr yield lower at end of week. Yield Curve flatter
- Stocks choppy too, but essentially unchanged by Friday
- "Rate sheet influential" MBS outperformed by TSYs...5.5s and 6.0s best coupons. Current coupon prices were higher by Friday. Mortgage rates stick to range. Here is FN 4.5 week over week...
The Week Ahead...
- Supportive time of month for MBS. Massive index extension means added demand for longer life MBS (RATE SHEET INFLUENTIAL). Implied volatility generally lower ahead of NFP. Prepayment reinvestments
- Regardless of supportive events...if benchmark prices are lower, MBS prices will be lower and mortgage rates will increase. (Supportive events may help MBS outperform TSYs yield spread-wise).
- No TSY supply = helpful. There is TSY supply announcement though...3s/10s/30s amounts on Thursday.
- More Seasonal Slowness = more choppy price action
- READ ECON CALENDAR
Why is Beginning of Month Supportive Time for "Rate Sheet Influential" MBS?
Supportive Event #1: Prepay Reinvestments
Each month MBS analysts and traders spend a considerable amount of time forecasting borrower refinance behavior. Borrower refinance behavior (or any action associated with paying off your mortgage) is revealed through MBS portfolio prepayment speeds. Prepayment speeds are THE key determinant in the valuation function of MBS. If prepays increase or decrease more than expected it can drastically alter the value of an MBS holder's portfolio.
At the beginning of every month, the principal prepayments from the previous month are reported. The "paid off" loan principal (of the mortgages you own) is deposited in the portfolio holders account. This is straight cold cash...funds that can be reinvested!!! Depending on the interest rate environment those funds might be reinvested in new MBS....which adds funds to the demand side of the MBS market. For example, if portfolio "paydowns" totaled $106bn this month, that is $106bn that could be spent on new MBS. That is a SUPPORTIVE EVENT.
Supportive Event #2: Attention to Settlement
In the TBA MBS market, at the time of the trade, the buyer and seller agree to the type of MBS (FN,FRE,GN), the coupon, and the price...they do not however provide the specific pool details of the trade. Trade settlement dates are preannounced every month by SIFMA. Two days before settlement date sellers are required to notify (notification day) buyers of the specific details of the pool that the buyer agreed to purchase from the seller. The pool details are required to meet specific standards that were agreed upon at time of trade. Two days later the trade is settled!
These events occur at the beginning of every month. As the calendar grows closer to settlement date MBS market participants begin to pay much closer attention to the TBA MBS market because a profitable opportunity may arise. This takes fixed income investors attention off of other relative value securities and focuses it more intensely on mortgage world!!!
Supportive Event #3: Less Interest Rate Volatility
At this point in your education process we hope it has become clear to you how important the process of forecasting expected cash flows is in determining the value of any fixed income security. When pricing the value of a fixed income instrument the most important issue is predicting the future path of interest rates...or the expected volatility of interest rates over the time period in which you expect to hold a specific fixed income investment.
Future interest rates are not impossible to predict, but are extremely difficult to estimate with a high degree of accuracy. Predicting future mortgage cash flows not only depends the expected behavior of borrower refinances and new home buying trends (see explanation above)....it depends on the anticipated volatility of benchmark yields (TSYs).
Investopedia's Plain and Simple: Volatility refers to the amount of uncertainty or risk about the size of changes in a security's value. A higher volatility means that a security's value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security's value does not fluctuate dramatically, but changes in value at a steady pace over a period of time.
What do lower interest rate volatilities have to do with the beginning of the month?
The US Government has scheduled the release of its Employment Situation Report (Nonfarm Payrolls) on the first Friday of every month. The entire marketplace is sensitive to changes in the labor market. The importance of this report can have major effects on trading positions, therefore in effort to protect portfolios from the possibility of volatile price swings, market participants generally set a neutral position or move to the sidelines to wait out the marketplaces reaction to the data. The Employment Report helps reduce the implied volatility of interest rates!
Furthermore because market's are relatively calmer, it is cheaper to hedge your MBS positions with options contracts. All in all lower implied volatility has a positive effect on the valuation of "rate sheet influential" MBS coupons....great timing considering the previous supportive events.
These three events combined are very supportive of the MBS market....which is why we get excited as we approach settlement date!
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