When the market panics it seems like anything goes. But there actually are some things mortgage investors should remember historically tend to occur.
One is, of course, a “flight to quality.”
As long as there is a flight to quality, investors' money “is going into Treasuries, and it is going into gold,” Patrick Hennessy, senior financial analyst at the Mortgage Market Guide, noted in an interview.
Interestingly, even a rating agency's downgrade of the United States' top investment-grade long-term rating—while it certainly added to global economic concerns roiling stocks—had not done much to shake investors' faith in U.S. Treasury debt.
As Mahesh Swaminathan, managing director and head of MBS strategy at Credit Suisse, noted in a recent interview: Despite the recent U.S. downgrade, U.S. Treasuries through the early part of last week generally were still “catching the safe-haven bid.”
Maybe Standard & Poor's downgrade didn't hurt the appetite for Treasuries because, among other reasons, ratings generally are not used much in the government securities market and at the time of this writing it was still possible to get two rating agencies to attest to the U.S.'s top investment-grade status.
But getting back to what it means for mortgages, when there is this flight to quality, besides lower rates and plummeting stocks, clearly Treasuries are usually more in demand and run up in price.
There also is an argument to be made, negative convexity and the GSEs' questionable future aside, that MBS with government or government-sponsored backing have pretty equivalent credit to Treasuries and more yield.
“Really, their relationship to Treasuries has not changed at all from a credit standpoint,” Chris Flanagan, head of U.S. mortgages and other structured finance research at Bank of America Merrill Lynch, said in an interview last week.
Some researchers were indeed reminding investors of this. It may be worth considering in a flight-to-quality scenario for investors who think underwriting will remain tight enough to head off enough prepayment risk in the sectors of the MBS market they might buy in, and are confident the U.S. will continue to back the sizable MBS market it is involved in.
But remember the other thing that tends to happen in a panicky market is that it can change its mind at any time. For example, consider last Thursday morning when better-than-expected jobless claims reversed the flight to quality. As quickly as panic starts, it can end.
When stocks recover and Treasury yields/rates drop, a move into higher-coupon MBS from lower-coupon MBS due to the former's relatively higher yields and decrease in prepayment risk is likely. Of course, as quickly as a market can recover it can plummet again, too.
This is why hedging usually picks up during a volatile period. So investors may want to have adequate hedges in place before there is one.
Finally, remember that whenever volatility puts a market in a position where longer-term rates are relatively higher and short-term rates are lower, it is likely the so-called carry trade will become attractive as investors and finance longer-term debt with less expensive shorter-term debt. There was some talk about this last week as the Fed did say it plans to hold short-term rates low for a while.
