Mortgage Sector Boosted Thanks to Low Volatility and Dovish Fed

(Bloomberg) -- The mortgage sector has outperformed U.S. Treasuries by 39 basis points year-to-date, helped in part by a confluence of low volatility and a dovish Federal Reserve.

This is a pleasant turnabout for the sector after a dreadful fourth quarter when the Bloomberg Barclays U.S. MBS index underperformed by 52 basis points, its worst showing for the quarter since it lagged by 187 basis points to close out 2008.

The Fannie Mae 30-year current coupon spread to the U.S. Treasury 5-year/10-year blend has tightened back to levels last seen in October. It has also closed within a narrow 4 basis point range since Jan. 3, according to data compiled by Bloomberg.

The current volatility environment may continue, as forecasts see a slow, steady increase of just 30 basis points in both 2- and 10-year U.S. Treasury yields through year-end, with the spread between them holding steady. Investors have ratcheted down their forecasts for the number of Fed rate hikes this year to zero.

Lower volatility can help mortgage performance as MBS investors are by default short the embedded prepayment options. A drop in it can help improve sector carry and can also be a positive for spreads. Volatility, along with convexity, is a primary transmission mechanism for mortgage spread movements.

The latest Fed minutes suggest the central bank will soon end its balance sheet wind down, promising to usher in a new "normal" that entails holding $4 trillion in government securities on their books. Prior to QE, the balance sheet held less than $1 trillion, all in Treasury securities.

Consensus is for the central bank to continue to allow the $1.6 trillion of mortgages to roll off and reinvest the proceeds into Treasuries. So while this return to a low volatility environment may stick around for the short-term at least, revisiting the tight spread of 61 basis points seen in Sept. 2012 may not be in the cards.

To contact the reporter on this story: Christopher Maloney in New York at cmaloney16@bloomberg.net

To contact the editors responsible for this story: Christopher DeReza at cdereza1@bloomberg.net, Rizal Tupaz, Nikolaj Gammeltoft

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