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The drone of the yield curve grinding steeper and the screams of worried MBS buyers fleeing anything EXTENSION RISK related...

Since early April the 10 yr Treasury yield has risen 50bps, yet mortgages remained stable thanks to the block buying powers of the Federal Reserve (yield spreads have tightened). The tighter yield spreads between MBS and TSYs were beginning to draw some none Federal Reserve funded demand to our side of the stack, this augmented funding added liquidity and increased demand side support for mortgage rates. It was a GREAT MONTH FOR MORTGAGES...we essentially strengthened all month while the Treasury market weakened (we were off in our own little world!). Unfortunately this posture was predicated on the assumption that the Federal Reserve would continue to artificially flatten the yield curve via open market purchases. Well...after Wednesday, that "assumption" has been amended. The FOMC's lack of yield curve friendly verbiage put MBS buyers on the defensive.

When benchmark Treasury rates rise, the duration (expected life of cash flows) of "out of the money" (at par or below par) MBS coupons grows longer. The farther out of the money an MBS coupon is... the more it's duration will EXTEND when benchmark rates rise. This occurs because the borrowers backing those MBS pools will have no reason to refinance if their rate is below current market. This means "current coupon" MBS investors will be STUCK in an underperforming investment....an asset that is paying less than what the market is currently offering!!! (That is extension risk)

Plain and Simple: If benchmark interest rates move higher, available funds can be reinvesting at current market for a higher yield and more return. Because the holder of MBS coupon can't call the debt  due when interest rates rise (only a borrower has call option on their mortgage), that investor will be stuck in an investment that is UNDERPERFORMING. Hence...real money and levered money will stay away from anything extension risk related...like"rate sheet influential" MBS coupons.

That is why we have seen so much RED lately...blame extension risk for the REPRICES FOR THE WORSE.

Now What?

At this point everyone wants to know WHEN, HOW, and IF the Federal Reserve will flatten the yield curve. Until then...the Federal Reserve will be left to their lonesome to fend off any originator supply offerings...and they will probably be sure to get a good deal when they do buy! This means things could get a little choppy for a time...but, we have faith! This is not  grounds to enter panic mode. Remember: the Fed still has $845 BILLION to keep mortgage rates near 4.50%....plus month end/beginning MBS SUPPORTIVE EVENTS

Here is a bit of optimism for you regarding volatility in the Treasury market....Yesterday the one day put/call ratio on the 10 yr  was 0.90, compared to 0.37 on Wednesday...this signals sentiments are equalizing in the Treasury market as participants settle into the post FOMC paradigm.