Lets do a quick recap of yield spreads...
Debt issued by the US Government (Treasury bills, notes, and bonds) is considered to be the highest credit quality....also known as 'Risk Free'.
These 'RISK FREE' securities (TSY bills, notes, and bonds) are the foundation for all other interest rates. This is why Treasury securities are called 'benchmarks'. All other debt issued is considered to be less quality than US Treasuries. To compensate for higher risk of investing, because other debt is considered lower quality than US Treasuries, all other debt trades at a premium over the 'risk free' rate. This is referred to as a 'yield spread' over a comparable benchmark.
Comparable means: of similar maturity. For example you would compare the returns of a 10yr municipal bond to those of a 10yr Treasury note. To quote the yield spread you would say the 10yr muni note is trading 200 basis points over the 10yr Treasury note...written shorter it looks like +200/10yr Treasury.
Now to relate to Mortgages....
We always talk about MBS yields and their yield spread over a benchmarks.When discussing MBS yield spreads we are comparing the yield of an MBS coupon to the yield of its benchmark. A tighter yield spread means less yield basis points between an MBS coupon and its comparable benchmark. A wider yield spread means more yield basis points between an MBS coupon yield and a TSY note's yield. For instance we compare the FN 4.5 yield to the 10yr TSY note and 10yr swaps, these are our benchmarks with which we compare MBS performance to TSY performance.
There are several reasons why yield spreads move wider and tighter. It could be simple supply and demand dynamics, it could be credit quality of the debt. In the case of Agency MBS, credit quality is not a concern because FN/FR/GN MBS are currently guaranteed by the government. In terms of supply and demand dynamics, if there is less supply of "rate sheet influential" MBS coupons, and the market needs "rate sheet influential" coupons...then MBS coupon yield spreads will likely tighten against benchmark Treasuries because more accounts are buying MBS than TSYs.
At the moment, lender overlays, the general economic environment, and all the other roadblocks to qualification are prohibiting loan production from increasing. Low originator loan production is keeping supply minimal. The Fed's involvement in the secondary mortgage market combined with low loan production has kept yield spreads tight. Demand has been far greater than supply.
Do not confuse the spread between a benchmark debt security and a riskier debt instrument (like MBS, Corporates, and Munis) with spreads between the different debt maturities on the yield curve.
The yield curve can take on several different shapes, all of which imply different economic conditions and outlooks.
The yield curve can flatten one of two ways: Bear or Bull
A bull flattener is when yields in the long end of the curve are falling faster than yields in the front end of the yield curve. For instance if 10yr TSY note yields are falling faster than 2yr TSY notes, then the spread between the two TSY coupons would be tightening...or more simply put there are less yield basis points separating the 2yr note and 10yr note.
A bear flattener is when yields in the short end of the yield curve are rising faster than yields in the long end of the yield curve. For instance if the 2yr note yield was rising faster than the 10yr note yield. Although yields are rising, because yields in the front end are rising faster than yields in the long end, the yield spread between the 2yr and 10yr would be getting smaller, or tightening.
The yield curve can steepen one of two ways: Bear or Bull
A bull steepener is when yields in the front end of the yield curve are falling faster than yields in the long end of the yield curve. For instance, if the 2yr note yield was falling faster than the 10yr note yield, then the difference between the 2yr note yield and the 10yr note yield would be increasing...the yield spread between the 2yr and 10yr would be getting higher, or wider.
A bear steepener is when yields in the long end are rising faster than yields in the short end of the curve. For instance, if the 10yr note yield was rising faster than the 2yr note yield, then the difference between the 2yr note yield and the 10yr note yield would be increasing...the yield spread between the 2yr note and 10yr note would be getting higher, or wider.
How does the shape of the curve affect MBS coupons?
There is a tricky aspect to calculating MBS yields...you have to make an assumption on how long the MBS coupon's cash flows will last...more specifically you have to make an assumption on how fast borrower's will prepay their mortgage. While prepayment speeds are a function of supply/demand dynamics in the primary mortgage market (UW regs, funding, home equity, etc), they also depend on the shape of the yield curve. (More so supply/demand lately).
When the yield curve steepens, it implies interest rates will be higher in the future. If interest rates are expected to increase in the next 10 years, then the borrowers who are refinancing at current market interest rates will be less likely to refinance down the road because rates will be higher then vs. now. Who wants to refinance into a higher payment? Not too many people, there will be less incentive to refinance in 10 years if mortgage rates are higher than current market rates. That said, why would you want to invest in a current production (current market rate) debt coupon if rates are going to be higher in the future?
You wouldnt! This is called extension risk. When the yield curve steepens, demand for "rate sheet influential" MBS coupons usually falls....bad for mortgage rates. (However, lately no supply plus Fed spending has kept current coupon MBS yield spreads tight).
Plain and Simple: MBS buyers dont want to be stuck in a fixed income investment that isn't keeping up with its benchmark (benchmark yields higher than MBS coupon yield)...if benchmark interest rates increase, it implies rate sheet influential MBS holders could be investing their money in a higher yielding debt instrument...they could be earning more return/MORE CASH FLOWS!!!! (On a relative basis...yield spreads would be too tight)
It's already 12:25 so I am going to pause here for now....
The 10yr Treasury note is trading -0-03 at 100-26 yielding 3.527%. Still stuck in the recent range...
The FN 4.0 is currently +0-08 at 98-14 yielding 4.162%. The FN 4.5 is currently +0-05 at 101-01 yielding 4.375%. The secondary market current coupon is 4.300%. The current coupon yield is +77/10yr TSY and +60/10yr swap. Yield Spreads are tighter...
SOME LENDERS MAY REPRICE FOR THE BETTER
Here is the FN 4.5 two day...