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Vince Foster: As the End of QE Nears... A Perfect Storm is Developing


Slowing mortgage supply is presenting a quandary for fixed income investors.

Last week I urged caution in the fixed income space as the relentless rally in Treasuries was starting to exhibit signs of exhaustion. The week that followed would see the market continue to rally while easily absorbing supply in the 10-year and 30-year tenors marking new year-to-date low yields. The market simply won't go down.

There is a perception that investors are "reaching for yield" in some sort of perverse speculative trade, but the evidence is quite the contrary: no one wants to buy 10-year 2.50% coupons. The problem is most investors remain dramatically underinvested relative to their bogey. As I have said many times before it is the mortgage market that is the tail wagging the dog and there has been very little new supply since rates blew out last year so the market is repricing mortgages to find supply. However, this repricing is occurring without participation from buyers as MBS investors continue to add minimum to portfolios as they await the market reaction once the Fed ceases QE in October.

You have to look to further than the mortgage REIT (mREITs) sector as an example of investor sentiment. In a report last week, JP Morgan analysts note the lack of participation from the mREITs:

From the demand side, the private sector has not been largely uninvolved. REITs have remained essentially on the sidelines, buying only $6bn of agency MBS during the second quarter based on company filings thus far. Some REITs appear to be moving more towards a duration gap strategy, rather than one based on leverage, to generate earnings, either by removing hedges in the short end of the curve, or by shifting from 15-years to 30-years in MBS. Indeed, leverage for the industry fell further during the second quarter to only 5.6x, down 1.7x from the prior year (Exhibit 5). This is important because a leverage based strategy involves more MBS purchases than a duration based one. For instance, with around $300bn in assets and leverage of 5.6x, the industry has around $50bn in capital. Thus, every additional turn of leverage involves $50bn more MBS purchases, but this is not the case for an increase in duration gap.

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The mortgage REITs are a relatively small owner of total mortgages, but are one of the more active participants and are often drivers of activity at the margin. In fact these investors were largely responsible for last year's bond market blow up. They are notably gun shy having reduced assets by 21% year-over-year both in aggregate and as a percentage of agency allocation. In Q2 alone Annaly Capital Management (NLY) represented virtually 100% of the net increase.

I think mREITs and likely other MBS investors are sitting on the sidelines waiting on the Fed to get out of the way. At least these investors want to see what happens to spreads once the Fed ceases to take all the newly originated supply. The problem is going to be when that time comes and yields are still low and spreads are still tight. The closer we get to October the more pressure builds for these investors to get involved.

Remember that time when the market went down when everyone was sitting around waiting on it to go down? Me neither. The pain trade that I warned about in Why Long-Term Interest Rates are Falling and May Continue to Drop is still in play. As I noted back in April:

On March 24, Bloomberg First Word quoted me about why I thought the long end of the curve was rallying: "I smell a pain trade... as those sitting in the front waiting on rates to rise; long bond has been best performer." The pain trade is in play but can be averted if the market begins to discount a higher growth rate in aggregate demand. However this will require a big change in the current trajectory. If this doesn't materialize, the pressure on those short duration will be to extend duration exposure. As long as the 30-year yield remains below 3.50%, the pressure will intensify. With economic storm clouds on the horizon, I'd say the forecast calls for pain.

This is a scary time for bond investors because there is so much money that is waiting for yields to go higher. At some point there could be a capitulation trade and I don't think many investors appreciate just how low yields could fall. If we aren't already there pretty soon yields are going to spark convexity concerns among MBS holders who will be forced to hedge shortening duration due to increased prepays by buying longer duration. This could very well be the catalyst.

A perfect storm is developing. No one wants to buy these levels, but the longer investors wait on higher yields the more they may be forced to buy at lower yields. The next few weeks could be pivotal. Later in the week is the Fed's Jackson Hole conference where it is widely expected Janet Yellen will provide more guidance on the Feds exit strategy which remains largely unknown. After Labor Day the big boys come back from the beach and will be looking to position for the year-end trade. I remain cautious, but also understand that if the bond market doesn't loosen up between now and then investors will be forced in and it could be "Katy bar the door."

Twitter: @exantefactor
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