As Matt informed we have been experiencing some post auction price volatility as the street bounces back and forth between yield curve position biases...from flatteners to steepeners then back to flatteners...in that order. What I am saying is essentially this....
Traders were selling longer maturity TSY coupons this morning, then ahead of the 3 yr note auction the bias flipped back towards buying the short end of the curve....now after the auction, traders are indicating they favor longer term debt. This is most likely a function of weakness in the stock market. Which I would like to illustrate with this chart...
This is an chart of the S&P 500 since hitting lows in March. I have overlayed Fibonnaci retracement levels. First, if you have been reading the blog lately you should remember that MG and I have been spending a good amount of time discussing the 882-888 range. We have noted that these price points are key technical support levels...and if the S&P were to break through this support that weakness was likely to persist in stocks. Well 888 support has indeed been broken (62% retrace since late June/FOMC meeting low) and the S&P is currently testing 882....which, if is broken, will definitely still need to be confirmed tomorrow (882= neckline of mini head and shoulders pattern).
The weakness in stocks is helping the long end of the yield curve rally (traders favor flatteners). This yield curve "flattening" is occuring with $30bn in TSY note/bond auctions on the calendar tomorrow and Thursday. I say thank weakness in stocks for this timely flattening rally. In order to confirm that the 10 yr is still in "rally mode" we will have to break 3.45% and hold under that yield (btw 3.45% is key retracement level too!).
Now for MBS!
Recently we have been focused on two distinct price levels. These two price levels have provided firm resistance for our rate sheet influential MBS coupons. I am talking about 100-00 on the FN 4.5 and 102-00 on the FN 5.0. In the comments section of MBS MORNING, a reader asked why these two price points were so tough to break. Here is how I responded:
Its all about duration and convexity. As prices of benchmark TSYs move higher and yields inch lower (yield curve flattens).... the duration of "rate sheet influential" MBS coupons shortens/lessens, and negative convexity is reduced.
Plain and Simple: as Treasuries rally, prices of "rate sheet influential" MBS coupons become less sensitive to a rise in benchmark interest rates, they are less sensitive to EXTENSION RISK!!!
Lets apply this concept to current market conditions. As TSY rates move lower and the curve flattens, the duration of "rate sheet influential" MBS coupons is reduced. This allows certain MBS holders to move "down in coupon" to match the duration of their liabilities with the duration of their assets (loan servicers are big convexity buyers). This is why, recently, we the FN 4.5 and FN 5.0 have appeared reluctant to move over 100-00 and 102-00 respectively. Now that benchmark rates are moving lower, there is not as much negative convexity in the marketplace....prices of "rate sheet influential "MBS coupons are less sensitive to a rise in benchmark rates! There is more room to rally because durations are extending! If the long end of the yield curve keeps rallying and the curve keeps flattening (see 2s vs. 10s below), we will likely see the FN 4.5 and FN 5.0 venturing further into the 100-00 and 102-00 price handles.
There is a flip side though...interest rate volatility is still high. If benchmark interest rates (TSYs) rise, both the duration and expected life of "out of the money" (at par or below par) MBS coupons increase (longer life). The farther out of the money an MBS coupon is, the more it's duration and life will extend (can only extend so much though) when benchmark rates rise because those borrowers backing the loans that make up the MBS have no reason to refinance if their interest rate is lower than current market. So MBS investors holding "current coupon" MBS when benchmark rates rise are said to be exposed to a high amount of extension risk. This is where we see panicked selling of "rate sheet influential" MBS coupons. This is why "current coupon" MBS is said to be negatively convex...because their prices are far more sensitve to a rise in rates (extension risk) than they are sensitive to a drop in rates (prepay risk).
So because no trend has been confirmed, there is still a chance that a sell off in the long end of the curve could occur. That will likely limit the extent of which we see a "down in coupon" rally. For now...there is still enough negative convexity in the current coupon blend (4.5 and 5.0) to limit potential FACEMELTERS. But that could change if weakness in the S&P is confirmed...then 810 might our next stop in stocks and more room will be made for an MBS/mortgage rate rally.
Check it out....the FN 4.5 and FN 5.0 are holding over 100-00 and 102-00 while benchmark TSYs continue to rally.
Make sense? If it doesnt ask a question!
2s vs. 10s: 247bps (was at 258bps this AM...THAT IS FLATTENING!!!!)
MBS Market Alerts
