Market Economics | Interest Rate Strategy - BNP PARIBAS ...

flattening in a rally and steepening in a sell-off. That
is not so much the case for 5s10s, as this spread
shows little directionality (Chart 1). This, combined
with other factors, leads us to favor the 10y sector
along the curve (see “Treasury Curve and Fly
Opportunities” in this Market Mover for more details).
We express this view through a 5s10s flattener. We
started to scale into this position at 138.5bp.
Next we turn to allocation among various products
within rates.
Mortgages look fair but are likely to continue to
perform well
With the majority of convexity selling done, we turned
overweight on mortgages as convexity hedging in the
sell-off left mortgages cheap. Since then, lower
coupon mortgages have tightened especially on a
nominal basis, while not as much on an OAS basis
since the decline in volatility has kept OASs in check.
While our regression shows mortgages are fair at this
point (Chart 2), we continue to remain overweight as
we expect new origination to be low as the majority
of the refinanceable universe is now out-of-money.
Despite an increase over the past two weeks, the
refinancing index is still about 60% below the highs
of 2010 and is at the lower end of the series over the
past couple years (Chart 3). Lower refinancing
signals slower prepayments, which was confirmed
with December’s prepayment report, in which speeds
were around 5% slower. Over the next couple of
months, we expect speeds to decline by another
50%. Refinancing accounted for around 80% of new
origination in 2010, so lower refinancing activity
should cause a drop in origination, which should in
turn be supportive of the basis.
Furthermore, with rates pulling away from their highs
and settling back into the low to mid-3% area, we
expect implied volatility to decline. This is another
factor that bodes well for the mortgage basis
(Chart 4).
The cheapening in mortgages due to convexity
selling in December had hurt lower coupons more
than higher coupons. In anticipation of a reversal of
this trend in the event of mortgage outperformance,
going into payrolls we favored lower coupons along
the coupon stack on a tactical basis, as NFP tends to
be a mortgage supportive event. This trade has
worked well and now, based on our regression
analysis, 4 and 4.5 butterflies look fair, while the 6
butterfly looks cheap (Chart 5). Therefore, at this
point, we would prefer higher coupons from a
valuation standpoint and because they offer the best
carry after accounting for curve carry and rolldown
and volatility, as shown in Table 1.
Chart 4: A Further Drop in Volatility Should
Tighten the Mortgage Basis
100
95
Mtge Current Coupon vs 10y Swap Spread
1y10y Swaption Implied Vol (R.H.S)
140
90
130
85
120
80
75
110
70
65
100
60
90
55
50
80
Jan-10 Apr-10 Jul-10 Oct-10 Feb-11
Source: BNP Paribas
Chart 5: High Coupon Mortgages Look Cheap…
Residual (ticks)
10
8
6
4
2
0
-2
-4
-6
Fly 4.0
Fly 4.5
Fly 6.0
-8
Cheap
-10
Oct-10 Nov-10 Dec-10 Jan-11
Source: BNP Paribas
Table 1: …and Offer the Best Carry
Drop
Curve
Hedge
Convexity
Cost
Total Hedged
Carry
FNMA 3.5 9.1 9.9 0.9 -1.7
FNMA 4.0 10.3 9.2 2.6 -1.6
FNMA 4.5 10.8 7.9 4.7 -1.8
FNMA 5.0 10.0 6.6 4.2 -0.8
FNMA 5.5 8.0 5.5 2.2 0.3
FNMA 6.0 7.8 5.4 1.7 0.7
FNMA 6.5 8.3 5.4 1.8 1.1
Source: BNP Paribas
300
250
200
150
100
50
Chart 6: 10y TIPS BEs Back to Typical
Pre-Crisis Levels
10y TIPS Breakeven (bp) Current Value
0
Jan-06 May-07 Sep-08 Feb-10
Rich
Source: BNP Paribas
Bulent Baygun / Mary- Beth Fisher / Timi Ajibola 13 January 2011
Market Mover, Non-Objective Research Section
26
www.GlobalMarkets.bnpparibas.com