The Treasury market looked to be on a trajectory toward higher long rates and a steeper curve, but the trend was interrupted late Thursday by the announcement that the Fed had raised the discount rate by 25 basis points to 0.75%  At the time, the yield curve (measured by the 2-10 spread) was at an all-time wide of +293.  After the announcement, however, the curve flattened sharply, and by Friday’s close was trading at +286, in line with the previous steepness record recorded in mid-January (as shown in Chart 1 below).  Also of note was the widening of the 2-5-10 butterfly, which indicated that the 5-year lagged the rest of the curve late in the week.

Despite the recovery on Friday, long yields have been moving higher since the end of January.  The yield on the 10-year Treasury peaked at around the 3.80% level, not far from the upper boundary of a 2 Standard Deviation trading band of 3.90% to 3.95%.  What’s more interesting in examining the trading bands is to look at what the lower bands might be.  The two bands shown in the chart, measured over 40- and 60-day lookback periods, have diverged noticeably, with a 30 basis point difference between them.

This raises an important question of which level traders might view as representing the lower end of a trading range.  My guess is that traders will view a move through the 40-day lower band (i.e., something around the 3.50% level) as a breach requiring significant duration adjustments.  A couple of things to note:  the 3.50% level represented the rate lows hit before the February rise in rates, and was also the highs reached when rates bounced within a narrow range in the second half of 2009.

Despite the recent moves in the market, realized volatility remains under pressure.  As the chart indicates, realized vol for the 10-year Treasury is at levels matching those experienced in the fall of 2007.  Moreover, realized vol calculated using the shorter (40 day) lookback period recently moved sharply lower.  If this continues, it will threaten the 4 basis point daily level last seen in the first half of 2007.  This downtrend in vol may, over time, be reflected in a continued decline in implied volatilities.  As the chart below indicates, 3x10 implied swaption vols have recently declined to their lowest level since June 2009, in part reflecting lower levels of realized swap volatilities.  All things equal, a further decline in implied vols would tend to support MBS valuations and put downward pressure on spreads.

Agency MBS performance last week was fairly weak, although levels were skewed by exogenous factors.  As indicated below, the 30-year current coupon spread ended the holiday-shortened week about 4 basis points wider, due in part to serious weakness in conventional 4s.  (For context, the chart also shows the average spreads to interpolated Treasuries and swaps for the first half of 2009.)

The passthrough market was roiled by the announcements by Freddie Mac and Fannie Mae that they will be buying seriously-delinquent loans out of their pools.  Most of the analysis pointed out the following:

Freddie Mac will buy out “substantially all” 120+-day delinquent loans effective as of February, while Fannie Mae will begin buying its inventory out in March, and their buyouts will continue for a number of months.

Both GSEs will continue to buy loans out of pools as they become seriously delinquent.  Since the performance of loans in Fannie’s pools is significantly worse than that of Freddie, involuntary prepayments for Fannies will be faster in the future.  In turn, this means that speeds for premium coupons (which are generally comprised of loans with weaker credit attributes) will be faster than Fannies than for Freddies.

This was reflected in the major shifts in Gold/Fannie coupon swaps for premium coupons.  The chart below indicates that the swaps adjusted sharply after the announcement.  This was particularly true for 6.0s, which went from around +4/32s to ending the week at around ¾ of a point.  (See the following report for an analysis of the difference in speed and its impact on the theoretical value of the swaps.)

The MBA released its quarterly delinquency report for the fourth quarter of 2009 last week.  While the MBA’s data tend to be a bit stale, the survey is widely followed, and probably draws on the broadest sample of the loan population.  The survey indicated that while total loans in foreclosure continued to rise, a number of indicators suggested that the rate of deterioration has begun to slow.  For example, the percentage of all loans in any stage of delinquency declined by 1.76%, the first quarterly decline since Q1 2007.  In addition, foreclosures started in the quarter declined for all products, as shown in the chart below.

This trend is consistent with the stabilizing of new delinquencies across products, something first noted last summer.  For example, the chart below shows 30-day delinquencies for prime, alt-A and subprime products from Bloomberg’s non-agency database.  New delinquencies for all products have either declined (for subprime loans) or stabilized (for alt-A and prime products).

This implies that a form of positive selection taking place in the loan populations.  Normally, voluntary prepayments remove the better credits from the population, resulting in an “adversely selected” population.  In the current environment, high levels of involuntary prepayments have removed the weaker borrowers, causing the credit profile of the population to improve over time.

This suggests that the market may have weathered the worst of the credit crisis.  However, this statement requires some caveats.  The huge backlog of foreclosed homes will eventually need to be absorbed into the market.  How smoothly lenders are able to liquidate their REO inventories, and the impact of these liquidations on home prices, will strongly impact whether delinquencies can begin to decline from current levels.  The worst case would be if another wave of delinquencies is triggered by renewed weakness in the real estate markets.

Bill Berliner is a consultant based in Southern California.  His web site is www.berlinerconsulting.net.

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