U.S. mortgage bond yield premiums rise on Fed angst

NEW YORK (Reuters) - Risk premiums in the $4.5 trillion U.S. mortgage bond market rose to their highest in more than a month on Wednesday amid growing concern about how the Federal Reserve will end its market-dominating purchases.

With the Fed's plan to purchase $1.25 trillion of the securities by year end about 60 percent complete, investors are speculating the central bank will allow rates to drift higher to entice private investors into a market that has become too dependent on the central bank's support.

The outcome is all but certain, however, since the Fed must walk a fine line between enticing investors to fill its void and keeping mortgage rates low enough to foster recoveries in housing and the economy. For now, the bet is for higher rates.

Investors "are still trying to get in front of that trade," Jack Donahue, a managing director in Jefferies & Co's mortgage and asset-backed securities group told Reuters in an interview at the firm's Stamford, Connecticut, office on Tuesday.

Angst over the pace of the Fed's MBS purchases has been elevated since the central bank last week said it would extend a similar program for Treasury securities, whose yields also affect the rates lenders offer on consumer mortgages.

The Fed may have already begun a de facto extension of its program, having reduced its weekly purchases. At the current pace of about $21 billion a week, the Fed would acquire the $1.25 trillion by January 27, 2010, a month later than scheduled, Jeana Curro, a strategist at UBS Securities LLC in Stamford, said in a research note.

"Given how rich the mortgage (value) is currently, it would make little sense for the Fed to increase its individual purchase volume," Curro wrote.

Risk premiums on Fannie Mae-issued MBS to benchmark 10-year Treasury notes topped 1 percentage point on Tuesday for the first time since July 16, according to Thomson Reuters data. On Wednesday, the yield spread premium rose to 1.01 percentage point from 1.002 point on Tuesday.

The yield spread had narrowed near 0.5 point in May, from more than 2 percentage points in December.

Earlier speculation that MBS prices would plummet in a "cliff" trade, rather than gradually, appears to be easing, however, according to Donahue.

Key to avoiding a damaging blow to the "agency" mortgage market that finances the bulk of all U.S. residential lending will be the degree of clarity in the Fed's exit plan, Matthew Tucker, head of U.S. fixed-income strategy at Barclays Global Investors, told Reuters.

"If the Fed is able to scale back buying and communicate that to the market, while you may see rates rise you might avoid that cliff event," he said.

Theoretically, rising mortgage rates and an ensuing drop in issuance would entice private investors to boost their demand, said Jefferies' Donahue. Treasury rates above today's 3.45 percent level also factor into that scenario, he added.

"If in December we have a 3.25 percent to 3.50 percent 10-year yield, then we've got a problem" in terms of the Fed's exit from the MBS market, he said.

(Editing by Dan Grebler)