Tuesday, February 12, 2013

What drove the 30yr mortgage rate higher?

After this post in early December discussing the possibility that MBS, particularly the 30yr FNMA had become a "crowded trade", we've received numerous e-mails arguing that based on the Fed's recent actions, agency MBS has more upside. Furthermore, the US consumer got so used to mortgage rates constantly moving lower, the reversal (discussed in that post) of that trend seemed unfathomable to many. But that is in fact what happened as the 30yr mortgage rate stopped declining.

Source: Bankrate.com

This reversal in mortgage rates was in fact driven by the sell-off in long-dated agency MBS, which many argued would not happen this quickly - yet here we are.

Source: Mortgage News Daily

There are a number of reasons for the sell-off and the recent (mild) rise in the 30y conventional mortgage rates:

1. Dealers have built up a massive inventory of this paper, making it a bit more vulnerable to a correction.

2. Treasuries have sold off materially since early December (about 35bp yield increase on the 10y note), dragging MBS with them.

3. Some institutional investors are preparing for the Fed's eventual exit by unwinding their MBS holdings.
Reuters: - The PIMCO Total Return Fund, the world's largest bond fund run by Bill Gross, decreased its mortgage holdings to its lowest level since mid-2011, ahead of the prospect of higher interest rates and emerging inflationary pressures.
4. The Fed's purchases have been increasingly focused away from the 30yr FNMA, which they probably view as overpriced, and more on the GNMA and the shorter maturity FNMA (such as 15yr) bonds.

Source: JPMorgan ("Conv." stands for "conventional")

That's one of the reasons the 15yr mortgage rate has not moved up as much as the conventional 30yr.

Going forward, the direction of agency MBS paper is less clear, particularly given the tremendous dependence on the Fed who will be growing its balance sheet to unprecedented levels. The upcoming US sequestration cuts could in fact push treasuries higher (by slowing economic growth), with MBS following. On the other hand institutions will certainly become more cautious on their MBS holdings, given the increased rate risk.

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