The Mortgage Bankers Association announced its refinance index grew 4% this past week. It's an announcement that should come as no surprise to mortgage bond investors, as concerns mount on the possible three-year non-agency MBS rally reaching the beginning of the end.

Bank of America Merrill Lynch (BAC) noted in its securitization report there remains many more mortgage borrowers who would benefit from refinancing, primarily out of negative equity, and the Federal government is behind making that happen.



Rates will likely remain compressed as the unemployment rate slightly increased, which eased investor’s immediate concerns about the Federal Open Market Committee’s commitment to the open-ended third round of quantitative easing.

"We also find evidence that both conventional and unconventional easing boost mortgage refinancing loan applications," said Goldman Sachs (GS) analysts in an email to clients.

"There is considerable volatility in the refinancing loan application series, but casual inspection of the exhibit [click Exhibit 3 graph below] suggests that major unconventional easing events have coincided with a rise in applications," write the analysts David Mericle and Sven Jari Stehn. "()



"We shift to an overweight stance from neutral on the MBS basis, recognizing the favorable near-term outlook for rates," the analysts stated.

Click on the chart to view mortgage trade.

Lower rates and easing concerns about QE3 may support MBS in testing the tight end of the trading range expected for production coupons. 

Production coupons are expected to trade up from the previously estimated range due to increased roll activity by the Federal Reserve, FOMC commitment concerns with QE3 and risks from higher rates, the report said.

"At the wide end of the range, higher spreads and yields will entice buying interest from banks, REITs and money managers, supporting valuations," the analysts stated.

Click on the chart to view coupon spreads.

Additionally, the sharp increase in 10-year Treasury yields to more than 2% brought back concerns over MBS convexity hedging flows, which was similarly noted in a recent Royal Bank of Scotland (RBS) report.

With the Fed remaining sensitive to its outsized footprint, there is possible room for shifts in Federal securities allocations. 

As a result, mortgage rates may rise to an extent where investors will look to exit the housing market, and thus end the non-agency MBS three-year rally.

"We are growing increasingly concerned that the euphoria will turn to disappointment at some point in the near future, as the inevitable profit-taking leads to a price correction," said BofAML's Carr and Flanagan.

"As a result, we re-iterate our recommendation to slowly rotate out of riskier securitized products and into duration," they add. "We doubt that the top in prices has been seen, but we do believe that we are nearing the end of the post-crisis rally in securitized products that began in early 2009."