We just said that investors are paying 102% of the face value of a bond in certain cases right? So what happens if they are not interested at that price any more? No more liquidity for the mortgage market. So how do you combat this? In a nutshell, the market forces of supply and demand take care of it. If demand for a bond is low when the price is 102.00, then the sellers of the bonds may lower the price to 101.50 to ENTICE investors to start buying again. And what did we already say would happen to the YIELD when the price got lower for a particular issue? It goes UP because the same money the investor was going to spend, now buys more shares. So their rate of return per dollar spent (yield) goes up.
Those pricing adjustments from 102.00 to 101.50 should look familiar. They move in exactly the same proportion to YSP. Although Big Bank A has to pull profit off that for themselves, THE PRICES OF MBS ALWAYS MOVE IN DIRECT PROPORTION TO THE PRICES (YSP IF POSITIVE, DISCOUNT IF NEGATIVE) OF THE MORTGAGES FROM WHICH THEY ARE DERIVED.
That is why we want to follow MBS instead of any other treasury or index in order to gauge the direction of the market. If investors are wanting to buy more MBS, then the prices are going to go up (Price vs. Demand function). Higher prices mean that Big Bank A makes more on a given coupon, which means they can originate a loan for your clients with either a slightly lower interest rate or a slightly higher YSP. Your choice!
So that is the theme of any mortgage market analysis. We want to assess the movements of MBS prices (which change by the second), in conjunction with the macroeconomic climate, in order to determine which way they might be headed and what future events can have an impact.
For instance, inflation data being negative hurts bonds because bonds return a fixed income. So if inflation has devalued the dollar over time, the bond is not really worth as much as when it first was purchased. So high inflation makes investors seek higher yields in order to get on that boat. Another popular correlation is that a booming economy draws money out of bonds and into more rapidly appreciating stocks. This causes bond owners to lower the price to entice buyers which raises mortgage rates. That is why, if you look at a historical chart of recessions and interest rates, you will almost always see recessions coincide with low rates.
Beyond that, there's only a little more you need to know when reading my analysis.
- First of all, there are several coupon rates ranging from
4.5%-7.5%. Right now, we primarily track the 5.5% coupon and the 6.0% coupon
as most of the trades are taking place in that range, giving us a higher sample
size and thus more reliable data. We will always report on the bond coupons
that are closest to PAR for this reason (par meaning a cost of 100.00).
- Bonds move in 32nds. So 101-32 would actually be 102-00.
And 101-16 would actually be 101.50 in decimal form. So when you see prices
improve by 16/32nds, that means that at some point in the future, lenders
have the ability to improve the YSP on rate sheets by .500. NOW, in this day
and age, lenders are not quick to pass on a price improvement to its full
effect. They want to see the market hold its gains for a bit. However, if
the market worsens, they will hedge their positions by taking even more away
from you than they have lost on price. This is just smart business, and it's
a balancing act between lenders to see who reprices and by how much. I will
often times refer to 32nds as TICKS. So if I say "we're down
6 ticks on the 5.5," that would mean that the 5.5% coupon MBS has declined
in price by 6/32nds from yesterday's close. Lot less typing my way!
- Tight or Wide. Bond investors have a choice between MBS
and other types of bonds. The benchmark competitor is the US 10 year treasury.
MBS price relative to treasury price is important because even if mortgage
prices go up on the day, if treasury prices go up a whole lot more, the MBS
will still be the better investment all other things being equal. Because
there is a significantly higher amount of risk in MBS than in treasuries,
the MBS prices will ALWAYS be lower than treasury prices for a similar coupon
amount. So when prices rise on MBS and "close the gap" on
treasuries, we say "MBS are trading tighter." You might also hear "tighter
to the curve," meaning the yield curve. Wide is simply the opposite.
- Graphs. Hopefully the graphs I've been posting make much
more sense now. They are simply tracking the curve of the price of a particular
coupon throughout the day. As the curve gets higher, rates have the potential
to go lower and vice versa. There is a school of thought known as "technical
analysis," which some think is crazy voodoo, while others think it is gospel.
Basically, technical analysis throws all economical analysis out the window
and simply focuses on the numbers, what they have done in the past, their
propensity to "obey" certain trends, their resistance to certain price floors
or ceilings, etc... I am a fence-sitter when it comes to Technicals.
I will comment on them, but always keep in mind that technical analysis must
be considered in conjunction with the rapidly changing economic climate.
So for instance, if I say "there is a price floor today that has been established at 99-16," that means that bond prices have resisted going below the horizontal line on the graph at the 99-16 mark. If bonds then were to break through that floor and go lower, it could indicate a potential increase in pressure to sell, which would hurt rates. Hope that makes sense.