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After the financial crisis, the Federal Reserve took unprecedented action to push interest rates down in an attempt to reignite growth in the economy. The Fed has pushed rates down by purchasing trillions of dollars of mortgage backed securities and treasury bonds. Recently, Fed Chairman Bernanke announced that the Fed would likely scale back its purchases of mortgage backed securities and treasury bonds in the coming months as the economy shows signs of improvement. That scared the interest rate markets which have been at all-time lows and fueled the dramatic spike in rates that we have seen recently.

How are rates determined:

Generally, the lender will sell their mortgages to a third party investment institution shortly after issuing them rather than holding them to maturity.

The institution that buys the individual mortgages then packages or bundles them along with large numbers of other mortgage loans into security instruments known as Mortgage Backed Securities.

The Mortgage Backed Securities are then divided into shares and offered to other investors. These investors then receive a return on their investment. Clearly it is important that people keep making their mortgage payments in order for the MBS market to remain healthy.

There is a constant tug-of-war between what investors (buyers of MBS) are willing to pay for the MBS shares and what mortgage borrowers are willing to pay for a mortgage rate. This is the mechanism that determines the mortgage rate.

If MBS investors are confident that very few people will get behind or default on their mortgage payments, the MBS shares are bid up because the risk of default is low and the investors are comfortable with a lower rate of return on their money as they believe it to be a safe investment. This is usually indicative of a low or falling rate environment.

On the other hand, if MBS investors are concerned that there will be more defaults on mortgages, the MBS shares get sold off. When the shares fall, the investors need more incentive to hold their MBS or to buy more, and thus interest rates must rise to attract the investors and compensate them for their risk.

Summing Up:

As the Fed has been purchasing more than 50% of the MBS market for many months, rates were pushed to all-time lows. This attracted borrowers and home buyers and helped real estate prices recover after the housing bust. Now that the Fed has decided that it will likely scale back its purchases in the coming months, the interest rate markets realize that they must adjust to having that much less liquidity and are repricing accordingly. The interest rate spike should not come as a huge surprise as most markets would be in a significant state of adjustment if more than half of the buyers stopped buying.

The mitigating factor to rising rates:

The global economy is very slow by historic standards and inflation is generally very low. Investors are hungry for a safe place to put their money and get a yield. As interest rates rise, bond prices fall. This makes bonds more attractive to investors because they then see a higher return on their money which should in turn bring in global investor demand for bonds and MBS that yield more. The demand for these securities should help to slow the rising rates at levels where a preponderance of investors feel that they are being compensated for their risk and making an adequate profit.

Trading The MBS Market:

The primary ETF for Mortgage Backed Securities is MBB. Watching how the U.S. 10 Year Treasury Bond trades appears to give a slight lead on where the MBS market goes. At this point, I would seriously consider being short MBB while risk is being priced back into the mortgage market as the Fed contemplates its exit from the $85 billion asset purchase program.

Should the U.S. stock markets roll over and correct significantly, it is likely that the rise in yields would be slowed or temporarily reversed. This might be a good point to get short MBB.

Watch for demand coming back into bond funds as yields rise to the point where they are attractive to investors. This would likely be a good signal to cover short positions in MBS.

The threat to this short MBS trade, in my view, is serious deflation. If it is seen that the general economy is sliding into a Japanese style deflationary cycle, yields will likely go much lower and being exposed to a short MBS position would probably not be a profitable trade.

Chart foriShares Barclays MBS Bond

Disclaimer: Nothing in this article is to be taken as professional financial advice, nor is it a solicitation to buy or sell any type of securities. All financial decisions are your own, seek professional advice before taking action.

Source: Understanding And Trading The Mortgage Market