Low trading volumes in nonagency mortgage-backed securities signal what Bank of America Merrill Lynch analysts are calling the end of the Great Rotation.
During the rotation, high-yield sectors, including subprime, experienced exceptional returns, but change is afoot, BofA-Merrill Lynch said.
The recent nonagency declines occurred as agency MBS yields moved higher in response to suggestions that the Federal Reserve will begin to unwind its quantitative easing program sooner than initially expected.
"The declining non-agency trading volumes in recent weeks may be reflective of a possible post-Rotation order, where yields could simply stagnate at low levels, trading volumes drop further and stay at low levels, and investors simply sit on the declining stock of non-agency MBS that they have already purchased," said Chris Flanagan and Justin Borst, MBS strategists of BofAML.
They added, "In that environment, we could see that investors might be apt to switch back to lower yielding, higher credit-quality agency MBS since the yield pickup from moving into riskier credit alternatives is too low to justify the risk."
However, the market hasn’t made a complete shift to a post-Rotation world just yet because the housing market continues gaining momentum, which is expected to provide an upswing in subprime prices, BofA-Merrill said.
Moreover, there are still uncertainties regarding how agency MBS will perform as the housing market increases expectations of an early Fed withdrawal from QE3.
When the post-Rotation environment finally occurs, there are two issues the market will likely confront: the stability and the length of the housing recovery along with the mortgage origination landscape.
BofAML upgraded its 2013 home price growth forecast to 8%, attributing the prediction to QE3 because the program continues to push housing upward.
Thus, the near top for housing will occur in the third quarter of 2017, which will be followed by several years of negative or flat growth, the analysts explained.
"From a valuation perspective, we think the possibility of a 2017 home price peak may eventually imply overvaluation of non-agency MBS, if the market inappropriately extrapolates near term strength in housing for an extended period," the analysts said.
The practical result of QE is that mortgage refinancings remain elevated and continue to dominate the origination landscape. For instance, 72% of originations reported in 2012 were refinancings and a similar share is expected for 2013.
Additionally, the Fed’s MBS purchases will help maintain the dominance of government financing, as the purchases keep the securities attractive.
"Over the next year, we anticipate that the pool of all borrowers who can refinance will have refinanced and that refinancing origination volumes will dramatically decline. This creates the opportunity for the Fed to dramatically reduce or even end its MBS purchases without causing much disruption to the market," BofAML said.