MARKET MOVER - BNP PARIBAS - Investment Services India

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This section is classified as non-objective research be hoovering up subtantially all agency mortgage origination for the foreseeable future, as part of their open-ended QE3 program. The intent is to encourage – or arguably coerce – investors into allocating out of agency MBS and similarly situated products, and re-invest by going down in credit or into equities. Despite the "crowding out" effect, many investors are captive – in whole or in part – to the rates market. These include the investment portfolios of commercial banks, state and local governments, central banks and portions of pension benefits and insurance obligations. These investors are substantially confined to high-quality deeply liquid assets, such as US Treasuries and sovereign debt, agency debt and agency MBS, other highly rated sovereign agency and supranational paper, AAArated covered bonds, and, in some amount, AA or better corporate or securitized debt obligations. Agency MBS have long been a favoured product in many of these investment portfolios to increase yield. Although we expect the Treasury curve to continue steepening in the medium term, yields in maturities out to 5 years should remain well-anchored, due to the limited opportunities for diversification, the shrinking supply of agency debt and the Fed’s wholesale absorption of MBS. Agency callables and bullets have now become the standout winners on a relative value basis among the rates products. For investors, we strongly prefer callable agencies to lower and current coupon MBS. Both 10nc2y and 7nc2y berms are projected to outperform FN 2.5 and 3.0s, respectively, over a 6m horizon in this environment. The 7-year sector of the agency curve is also the steepest among the rates curves and 5- year to 7-year agency bullets outperform similarduration Treasuries and swaps. Repo for agency paper vs Treasuries is now flat to a measly 1-2bp. Amid declining agency debt supply and increased buying as captive investors are forced out of MBS, we see further agency to Treasury spread compression ahead. MBS Our economists expect QE3 MBS purchases to continue at the USD 40bn per month pace at least until year-end 2013, and possibly into 2014. Including reinvestments of maturing agency debt in the Fed's portfolio into agency MBS, the net demand from the Fed would exceed USD 500bn over the next 12 months. The issuance of the TBA deliverable bonds where Fed purchases have been concentrated was negative USD 172bn over the past 12 months, roughly a negative USD 14.3bn per month average. Thus, the Fed demand for MBS is particularly high in relation to the negative supply of the bonds that the Fed has traditionally purchased. The QE3 announcement has driven MBS to very expensive levels, and mortgages are more expensive than Treasuries and to a greater extent than during QE1. While there was some pullback after the massive initial tightening, MBS, once again, outperformed Treasuries in Wednesday’s rally. In addition, with the announcement of QE3, volatility has declined. The decline in vol has helped improve hedged adjusted carry across the coupon stack. Empirical durations have also come off, improving MBS carry. While we expect MBS to continue to outperform Treasuries, riskier assets may perform even better. The Fed would effectively be buying MBS from money managers who are overweight MBS and GSEs that have been forced to reduce their portfolios. Rather than explicit sales of MBS, we mainly expect reinvestments of mortgage prepayments and, due to declining agency debt outstanding, into other products. We estimate that money managers could experience USD 150bn to USD 200bn in prepayments and agency debt outstanding could decline between USD 50bn to USD 200bn over the next year. Table 1: Market Going Through Some Growing Pains, but Risk Appetite Should Be Supported in the Medium Term Treasuries, Duration and the Curve Current pullback to persist through month-end, so turn neutral/slightly bullish tactically overweighting 10s vs. 5s and 30s. Long-term bear-steepening trend to resume, so stay nimble. Buy 4y1y receiver to benefit from lofty rolldown. TIPS We like breakevens coming out of the 10yr auction and hope to add to our positions again on significant dips. Short-Term Financing Repo is likely to stay elevated through year-end and provide a soft floor to short-term funding rates. Expect compression in 3s1s as 3mL declines faster than 1mL Agencies We strongly recommend 7nc2y to 10nc2y berms as alternatives to current and lower coupon TBA mortgages based on their projected outperformance. MBS Maintain MBS overweight as demand is strong and supply is negative. Carry has improved with declining volatility and lower empirical durations. Source: BNP Paribas Bülent Baygün / US Interest Rates Strategy Team 20 September 2012 Market Mover 20 www.GlobalMarkets.bnpparibas.com
This section is classified as non-objective research MBS: Shorter Empirical Durations Under QE • QE3 is likely to bring in lower empirical durations akin to QE1, due to stability in rates and mortgage prices. • The 15bp to 30bp state-based upfront g-fee amounts to a small 3bp to 6bp rate increase, based on the IO multiple of 5 used by the FHFA. With the Fed bringing an element of stability to rates and particularly mortgage prices, empirical durations have begun to decline. Chart 1 shows the ratio of empirical-to-trader hedge ratios for 3.5s and 5s; we chose just those two coupons as representatives to provide a clearer picture of the contrast between lower and higher coupons. While the ratios for all coupons are declining, the declines seem to be of a greater magnitude in higher coupons. Plus, the ratios are greater than one in 4.0s and lower coupons, but lower in 4.5s and higher coupons. A similar trend was observed during QE1, when empirical hedge were ratios shorter than trading ratios, particularly for higher coupons (Chart 2). We show 4.5s and 6s as representatives since the current coupon was much higher during QE1 than at present. Lower empirical durations would improve the hedge carry of MBS. The decline post-QE3 announcement has also helped to improve hedge adjusted carry across the coupon stack (Chart 3). We continue to expect MBS to outperform Treasuries, despite the richening, given steep demand from the Fed against a negative net supply. Clearly, carry is already attractive and should improve further with lower durations and volatility. However, as we discuss in an accompanying article, ”QE3 Impacts on US Spread Products”, riskier asset classes, such as corporates, may perform even better than MBS. State-Based G-fee FHFA announced that it would potentially implement an additional state-level g-fee (guarantee fee), starting in 2013, for five states: Connecticut (20bp), Florida (20bp), Illinois (15bp), New Jersey (20bp) and New York (30bp). This g-fee proposal is under comment period for 60 days. Lenders may pass the upfront fee as an adjustment to the interest rate on the borrower’s loan. The FHFA used the suitable IO multiple of 5 in their example to make the adjustment to the annual rate from upfront fee. This amounts to a small 3bp to 6bp rate increase, depending on the state. Chart 1: Empirical vs Trader Hedge Ratios – QE3 1.2 1.0 0.8 0.6 0.4 0.2 - Empirical Vs Trader 3.5s Empirical Vs Trader 5s Jan-12 Mar-12 May-12 Jul-12 Sep-12 Source: BNP Paribas Chart 2: Empirical vs Trader Hedge Ratios – QE1 2.0 1.5 1.0 0.5 Empirical Vs Trader 4.5s Empirical Vs Trader 6s - Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 Source: BNP Paribas 1M Hedged Adjusted Carry (ticks) 8 6 4 2 0 Chart 3: Hedge Carry Has Improved -2 FNMA 3.0s FNMA 3.5s FNMA 4s FNMA 4.5s -4 FNMA 5s FNMA 5.5s 7/2 7/16 7/30 8/13 8/27 9/10 Source: Yield Book, BNP Paribas The g-fee estimation is based on three factors. The first is the expected number of days that it takes an Enterprise to foreclose and obtain a marketable title to the collateral backing a mortgage in a particular state. The second is the average per-day carrying cost that the Enterprises incur in that state. The third is the expected, national average default rate on singlefamily mortgages acquired by the Enterprises. To estimate the magnitude of the state-level differences in the average total carrying cost, the estimation assumes that loans originated in each state will default at the national average default rate. Timi Ajibola 20 September 2012 Market Mover 21 www.GlobalMarkets.bnpparibas.com
Page 1 and 2: Market Economics | Interest Rate St
Page 3 and 4: Spain set to present its new budget
Page 5 and 6: The methodology All of the above in
Page 7 and 8: Ireland: What to Expect When You Ar
Page 9 and 10: Spain: Inching Closer to a Request
Page 11 and 12: UK Inflation: No Pressure • UK in
Page 13 and 14: US Housing: New Channels for Policy
Page 15 and 16: Japan: The Eastern Fiscal Cliff •
Page 17 and 18: an agreement that all budget-relate
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Page 33 and 34: Table 1: BNP Paribas' Inflation For
Page 35 and 36: Table 3: BNP Paribas' Inflation For
Page 43 and 44: Economic Calendar: 21 - 28 Sep (con
Page 45 and 46: Key Data Preview Chart 1: UK Cumula
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Page 55 and 56: Treasury and SAS Issuance Calendar
Page 57 and 58: Central Bank Watch Interest Rate EU
Page 61: For Production and Distribution, pl

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