Mortgage bonds lag Treasuries as uncertainty about rates surges

Growing uncertainty about the direction of interest rates spurred agency mortgage bonds to perform worse than Treasuries on Monday as investors braced for potential rate cuts to bring more homeowner refinancings.

Spreads for Fannie Mae current coupon mortgage bonds, a proxy for securities being created now, jumped 0.07 percentage point to 1.41 percentage point, on track for the most widening in a day since April. That's according to a Bloomberg measure relative to a blend of five- and 10-year Treasuries.

Relative weakening for MBS came as investors became increasingly unsure about the outlook for interest rates. The ICE B of A MOVE Index surged on Friday to its highest level since April, signaling greater expectations in the options market for interest-rate fluctuations.

Mortgage bonds tend to lag Treasuries when it's unclear where rates are going, because changes in yields can have a big impact on how many borrowers refinance their home loans — known as prepayments — and how long investors have to wait to get most of their principal back. 

"The twin evils of escalating volatility and mounting prepayment risk have weighed on MBS performance," said Kirill Krylov, a strategist Robert Baird & Co.

Longer term, some strategists believe that MBS could perform relatively well when banks start ramping up their purchases of the bonds. But factors like bank demand may take some time to materialize, Barclays wrote in a note on Friday. The bank said it recommends neutral positioning now