Agency MBS: Outlook for Agency MBS Basis

- "Over the past two weeks, agency MBS had significantly underperformed Treasuries. The sharp underperformance of the MBS universe could be gauged from the fact that the dollar prices of FN 4.5s have appreciated by only 6+ ticks and those of FN 5.5s and 6.0s have declined by close to 22-24 ticks even as the 10-year Treasury Futures contract had appreciated by 2-08 and the 5-year Treasury Futures contract had appreciated by 0-31+ over the past two weeks (Figure 1).1 This sharp underperformance of agency MBS had occurred even as implied volatility of interest rate options (both Gamma and Vega) had declined by 3-7 bps over this time period, which is unlike prior episodes of mortgage spread widening when MBS spread widening was typically associated with a spike in implied volatilities."
- "As regular readers are well aware of, our strategy team has been recommending a long-term underweight on the MBS basis versus Treasuries for 2H’10, primarily because of our expectation of the Federal Reserve not reinvesting paydowns on its existing MBS holdings back in the MBS. This would represent a significant net supply of agency MBS to the rest of the market and spreads will have to widen for this excess supply to be absorbed by private investors. However, even we are somewhat surprised at the pace of spread widening over the past two weeks."
- "Below we present an assessment of some of the macro-factors that are likely to drive agency MBS spreads over the next several weeks and outline our short-term and long-term trade recommendations on MBS basis:
• Issue #1: Reinvestment of MBS paydowns received by the Fed in Treasuries
• Issue #2: Elevated prepay uncertainty due of the possibility of streamlined refinancing
• Issue #3: Low absolute yield levels and relatively cheap MBS valuations
• Issuer #3: Servicers"

Nomura Special Topics 20100813

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