In this new era, trading mortgages has been challenging over the past year for investors due to a number of reasons.
In particular, massive mortgage-backed securities purchases by the Federal Reserve have impaired liquidity and market depth while policy changes have made prepayments difficult to forecast because of changes to the Home Affordable Refinance Program and Federal Housing Finance Agency leadership remain uncertainties, JPMorgan Chase said in its latest report.
Additionally, short rates have been anchored, rendering traditional measures of duration such as parallel rate shifts irrelevant, particularly for higher coupons, the banking giant noted.
"As a result of these factors, many inter-coupon relationships are no longer mean-reverting with the same frequency they exhibited in previous environments, and money managers therefore struggle to generate alpha using age-old methodologies such as regression analysis," said analysts of JPMorgan (JPM).
Investors expect the 2-year note on higher coupons to remain anchored for some time, as the central bank continues to open-ended third round of quantitative easing, making the correlation between price and rate moves anemic.
For all coupons, policy risk has made heading MBS far more difficult than before.
Furthermore, quantitative easing, HARP and government-sponsored enterprise reform have been key drivers of mortgage bond performance since the crisis, and these policy risks are difficult to hedge with other securities.
"Using historical data to fit current duration expectations would likely produce less predictive results today," analysts stated.
Regressing MBS prices versus a set of fundamental variables has been a bread and butter strategy for decades.
However, relative value in this current market is heavily influenced by policy risk.
"On a higher level, the variance of residuals has exploded since the financial crisis compared to more stable variance pre-crisis, suggesting that such markets are not mean-reverting around these basic fundamentals anymore, so mean-reverting trading strategies take longer to resolve," analysts explained.
As a result, the mega bank recommends that traders and investors use rich, cheap regression results with caution.
While creating variables for policy risk is challenging, it’s not impossible.
For instance, one can track HARP risk using the Mortgage Bankers Association’s HARP share of applications.
In general, it’s clear that the current market environment is challenging.
Duration is traditionally defined as price sensitivity for a parallel shift in rates, but the anchoring of the short-end has pushed higher coupon durations to nearly zero.
In contrast, lower coupons have been extending over time, making their hedge-adjusted carry less attractive to investors as costs have increased.
Finally, policy risks have made it challenging to rely on mean-reversion as a trading signal.
"Consequently, we expect investors will gravitate more toward basis trades at the margin as a means to generate alpha in the mortgage market this year," JPMorgan analysts concluded.