• Central bankers are going to dominate the outlook for the agency MBS market for yet another year. Elevated net issuance and Fed's balance sheet tapering creates a situation in which the private markets will need to absorb the highest level of supply in the MBS market in a given year since the crisis. We believe the macro environment will remain favorable for this supply to be absorbed at least for the first half of 2018, but there are potential headwinds during the second half. Risk premium across the market remains tight, and we are much more concerned about a correlated move wider rather than MBS widening in isolation. We like being overweight 30s over 15s. We favor sticking to production coupons (3.5s) in TBAs. We like owning pools in 4s and 4.5, specifically new-prod, high-LTV purchase, and I4 stories. We like low FICO in 3s.

 

  • Home sales and home prices continue to be the critical factors behind the year-over-year increase in net issuance with new and existing home sales contributing. Overall, taking off special factors in 2017 but anticipating further increase in net issuance, we think that 2018 net issuance could come in at $300 billion, same as 2017. Gross issuance may also be similar for both years at $1.25 trillion, but the mix is likely to shift more toward purchase.

 

  • 2018 promises to be an interesting year with $300 billion in net issuance and Fed's balance sheet reduction of $170 billion. Driven by limited C&I growth and UST to MBS reallocation, bank demand could exceed $150 billion. Money managers may add a similar amount due to inflows and credit tightening. Overseas investors may add $100 billion, REITs $35 billion and GSEs about $25 billion.

 

  • Continued improvement in housing, economic and lending conditions could push turnover higher but tempered by anemic housing supply. Barring a tail-risk rate rally, we see aggregate s-curves in 2018 similar to 2017. More locally, we see pockets of call risk in newer production. Potential tax reform could damp turnover and cashout refi's but encourage rate-term refi's to some extent, but the effect is likely to be felt gradually over time.The TIC data for September 2017 released today showed that foreign investors bought $8.9 billion in agency bonds. While they sold agency debentures, they bought $10.0 billion in agency MBS. Adjusting for prepayments, MBS demand may have been -$3.1 billion. After encouraging numbers in May and June, demand has been tepid the past three months.

 

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