Rates dropped as mortgage bonds rallied big and stocks were flat on a Fed pledge to keep overnight rates near zero through 2014, iffy New and Pending Home Sales, weak GDP, and doubts about investors in Greek debt to agreeing on losses they’ll take.

Greek debt negotiations will dominate market action early this week.

The latest looks like a deal where Greek bond investors exchange outstanding bonds for new ones with coupons as low as 3.6-3.75%, and take 50-70% losses in the process. If most private investors don’t agree, it could trigger credit default swaps (CDS) on these securities, leading a European bank liquidity issue, which is really a global issue, and U.S. rates could drop further in this scenario.

The week also begins with an EU summit that will focus on tighter fiscal union across Europe. But short-term, most sentiment hangs on the Greece deal.

Volatility will reign, with most probable scenario being low rates hold as investors focus on U.S. mortgage and Treasury bonds.

The week’s data breaks down like this:

Monday we’ll see the Fed’s preferred inflation measure, the Personal Consumption Expenditures Index (PCE), which is likely to be flat. Tuesday brings November’s Case Shiller home price report where we’ll find out if a losing streak extends into a third month or turns positive. Wednesday and Friday bring ADP and BLS jobs reports for January. Expectations are wide for both after blowout ADP (+325k private jobs created) and much better BLS (+200 nonfarm jobs created) for December. Also Wednesday is ISM Manufacturing for January which may show an improving trend extending into its 30th month. Plus 4Q earnings season rolls on all week.

Here I preview each item for those who want more details.

Looking at stocks, the S&P 500 closed last week at at 1316, flat on the week and well above its 200-day and 50-day moving averages of 1257 and 1255. Seems stock investors are awaiting signals out of Greece before committing further or pulling back. A possible deal impasse and/or CDS spiral on Greek debt could push the S&P 500 down to its 50 and 200-day averages. But given this unpredictable macro environment, analyst Robert Sinn put it best in his 1/28 Weekly Letter:

You can expect to hear people mention S&P 500 levels less often as they speak more in terms of individual names and in which sectors they want to be invested.

Looking at mortgage bonds (MBS), the 3.5% Fannie Mae coupon – a key benchmark lenders use to price consumer rates – rose a whopping 103 basis points last week to close at 103.69. MBS are now a comfortable 88 basis points above 25-day moving average and 125 basis points above their 50-day moving average.

Rates drop when bond prices rise like this, but rates only dropped .125% because lenders didn’t price all these gains into rate sheets until they see whether the rally holds—which again, is dependent largely on Greece to start the week.

The tricky balance is that U.S. data could continue its modest improvement this week, so if the EU situation stabilized even slightly, MBS would sell, pushing rates up. And lenders don’t want to get caught in that reversal so they price conservatively.

I’ll repeat my outlook for last week since the Greek deal is dragging on:

MBS and rates will hold or improve slightly if the Greek debt deal goes sideways. But if it’s reasonably clean -meaning there’s no event that triggers claims on credit default swaps and squeezes banks – then we could see U.S. rates rise short-term as investors shift out of MBS and Treasury safe havens into riskier assets.

BOTTOM LINE: Rates are absurdly low. Only a meltdown in Europe will cause U.S. rates to go lower near-term.

If you’ve been waiting for a rate bottom, this could be your week.
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Related:
-Refi Roadmap: A Locked Rate Isn’t A Closed Loan
-Stat by Stat: Recap Jan 23-27, Preview Jan 30-Feb 3

In fact, some believe that net issuance (new securities versus loans paying off) of MBS’s will actually be negative next year. The Fed is now reinvesting MBS paydowns, the Treasury’s selling of agency MBS will near completion, and the refi activity is likely to stop increasing further. So if supply drops, and demand continues, we remember from Econ 1A that the price will go up. And if you remember your bond math, when fixed-income prices go up, rates go down.

Besides the Feds, who are purchasing about $1 billion a day of agency mortgage-backed securities, REIT’s (also known as REITs) have had plenty of publicity this year surrounding their appetite for agency residential paper. But their stock prices, often more volatile than the rest of the market, have been in the doldrums for 2-3 months. What’s up with that? Investors are now assigning REIT’s more risk than in the past. This has been due to the risk of prepayments picking up, and REITs don’t perform as well when their portfolios of higher-interest rate loans pay off early and they have to invest the money in lower coupon product. The market is seeing increased prepayments driven by low mortgage rates and from HARP and now HARP 2.0. Other risks are seen from the drying up of repo lines (the main source of borrowed funds is repurchase agreements) and the possible loss of the SEC exemption from the Investment Company Act of 1940. (This would impact the favorable tax status that REIT’s have.)

Experts are quick to point out, however, that some of this can largely be avoided/mitigated with appropriate RMBS selection. Think about it: any REIT buying recently minted residential securities are buying pools filled with loans to credit-worthy borrowers due to tighter underwriting standards, and at current rates. It is easy to make the argument that loans made recently have rates that may be as low as they go, and is it worth the cost and effort for recent borrowers to refinance?

HARP 2.0 has thrown REIT’s a curveball, however, since a REIT with substantial holdings of RMBS backed by pre-2009-vintage mortgages with high coupons and no prepayment “protection” (such as low balances) will see increased prepayments. (A REIT focused on ARMs is a different matter, since agency ARMs with LTV’s above 105% are not eligible under HARP 2.0 to refi into another ARM.)

In a recent research piece Cantor Fitzgerald noted:

the main risks for mortgage REITs as interest rate risk, prepayment risk, liquidity risk, government/regulatory risk, and (for non-Agency mortgage REITs) credit risk. We note that mortgage REITs hedge to some degree against interest rate risk and prepayment risk.” For example, in mortgage rates slide higher, and few expect that until later in 2012, “it is possible that (a) the spread could narrow between yields on mortgage REITs’ RMBS and the cost of mortgage REITs’ repurchase agreements, thereby lowering net interest income, and/or (b) the net change in fair value of mortgage REITs’ assets and liabilities could be negative.

And if rates go the other way, it is possible that mortgage REITs’ RMBS could prepay faster than the speeds reflected in the prices that mortgage REIT’s paid for those securities, thereby (a) accelerating the amortization of the premium paid for those securities, and (b) lowering the yield at which the proceeds of the prepayments could be reinvested. But people smarter than the rest of us believe that mortgage rates are not heading down from these levels.

-The Only 2 Ways To Save Italy (Robert Sinn)
-Why Italy Is Dominating Markets (CNBC’s Patti Domm)
-Europe’s Solution Is More Integration, Not Less (CreditWritedowns)
-The Italy Factor Gets Ugly (CapitalSpectator)

-Bonds Beat Stocks: 1981-2011 (TheBigPicture)
-Great summary of underwater refi plan (FT Alphaville)
-CHARTS on Case Shiller Home Price Numbers (Bespoke)
-Intriguing Policy From Chicago Fed Pres (Bonddad)
-11 Ways To Ghost-Proof Your House (InmanNews)
-5 Most Profitable Horror Movies Ever Made (Minyanville)

Also below is a link to the consumer version I did earlier so underwater homeowners have a checklist to see if they qualify.
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-HARP Quick Guide: Investment Perspective
-I’m Underwater: Do I Qualify For New HARP Refi?

-More pictures & latest on Greece (Al Jazeera)
-Papandreou Prevails in Austerity Vote After Clashes (Bloomberg)
-Closing bell recap of market day (BusinessInsider)

It didn’t fade yet but I also noted that “rates will continue to rise and fall on each little development in the European debt crisis.” So let’s look at the latest in Europe and preview the October 17-21 week.

Recap Oct 10-14 Market Week
Overly optimistic interpretations of “less bad” news and data continue to drive trading.

Jobless claims last week were 404k, above but close to the 400k line, below which the job market is considered to be improving.

September retail sales were 1.1%, which was at the high end of expectations and the largest gain in 7 months.

Eurozone leaders are inching toward a new plan for recapitalizing banks and the bailout du jour for Greece. More below.

The result of this less bad news and data was that the S&P 500 rose squarely above it’s 50 day moving average (chart), and mortgage bonds (3.5% FNMA coupon) dropped below their 50 day moving average.

Rates rise when bond prices drop like this.

Preview Oct 17-21 Market Week
Here are next week’s economic calendar highlights with rate impacts:

Monster Earnings Week: This week is huge for earnings including reports from Apple, Microsoft, Intel, IBM, Citigroup, Bank of America, Wells Fargo, Goldman Sachs, Morgan Stanley, Coca-Cola, McDonald’s, and GE. Tech companies should be ok but financials may offset. Stock momentum was strong last week, contributing to bond selling that pushes rates up. Rates could rise a bit more on better earnings.

Manufacturing Reports: The October Empire State and Philly Fed manufacturing reports are released Monday and Thursday. Both reports were down sharply last month (-8.82 and -17.5 respectively). Any improvement will be in the ‘less bad’ category, which would bring negative rate sentiment. Rates even to up.

Europe Remains Huge U.S. Rate Factor: I’ll repeat a note from last week that market optimism about Eurozone bank safety nets misses the main point: Bank liquidity moves probably won’t stop defaults, they’ll just help manage liquidity problems when defaults come—and U.S. rates would likely benefit from Eurozone defaults. This needs to play out further, but there’s still no clear evidence supporting a sustained rate spike. It might not come this week since there’s new reports of progress, but this story is far from over, and the only bright spot is low U.S. rates medium term.

Technical Trading Factors: The 50 day moving averages noted above are important because there’s still room to drop from here—enough to push rates up another .125% to .25% near term. Charts (or “technicals”) are critical but ultimately impacted by economic fundamentals, which aren’t strong.

Inflation: September consumer and business inflation reports are Tuesday and Wednesday. No strong inflation trend here, so rates even.

Housing Starts & Existing Home Sales: Housing starts have been dismal and no big change expected. Existing home sales rose 7.7% in August, a five month high, so if this turns into a two-month trend, it will provide some optimism. Rates even.

Bottom Line For Rates: Rates could rise more next week on further perception of progress in Europe and corporate earnings, but it’s still reasonable to expect another dip to record levels in the coming months as Eurozone issues play out.

Here’s a MUST READ while waiting: How To Shop For A Mortgage.