Over the last month, mortgage-backed security prices have done better than Treasury prices, mostly because of supply (mortgage banker selling of $1-2 billion per day) and demand (the Fed alone is buying $1.2 billion per day) issues.

Could this relative price movement change direction?

Sure. Some broker-dealers believe that a sustained selloff in the rates market that will take the 10-year Treasury to 2.5% or above would be the most likely scenario in which MBS spreads would widen significantly. This is due to a number of factors, including a prediction that, assuming a selloff is caused by improving fundamentals of the US economy, the probability of Fed’s QE 3 involving agency MBS should diminish significantly in a rates backup scenario.

On top of that, IF rates were to see that big of a move, it would mean that volatility has increased – rarely a good thing for MBS’s. And when that happens, “convexity hedging” related selling from servicers and originators would probably lead to a sudden increase in the supply of agency MBS in this scenario, resulting in even more selling.

Lastly, domestic banks have been providing a very strong bid for agency MBS over the past 5-6 months, and in a rates backup scenario, their deposit growth is likely to be lower, meaning that banks would be unlikely to grow their holdings until rates stabilize again. Simple!