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Morgan Stanley Has a New Top Trade: Call It the Not-So-Big Short

Morgan Stanley sees a way to make money betting against U.S. residential mortgage-backed securities. Just don’t say it’s a “big short.” 

Spreads between Treasuries and agency MBS are poised to widen, according to cross-asset strategists at the bank. So they suggest selling short a pool of Fannie Mae-backed mortgages with a 3 percent coupon, while taking a long position of half the size in five-year and 10-year Treasury bonds.

Agency MBS “are structurally short U.S. rate volatility near all-data lows, at levels that show little premium to realized,” the team led by Andrew Sheets wrote in a note Wednesday. “Meanwhile, the spread over Treasuries that investors receive for taking this risk, as well as the credit risk from the mortgage pools and their guarantors, is historically narrow.”

Morgan Stanley

Morgan Stanley sees balance-sheet normalization from the Federal Reserve, global reflation and a more aggressive tightening of short-term interest rates from the U.S. central bank as factors that should foster more interest-rate volatility and buoy this trade.

Mortgage-backed securities “enjoyed outsized technical support as the Fed’s balance sheet increased historically, and net issuance is running at post-crisis highs as the Fed is reducing its holdings of MBS,” according to the strategists.

The chief risk, Sheets’ team said, is that market conditions remain relatively static -- and since the cost of maintaining the short position in agencies exceeds the yield on Treasuries, the trade produces a negative return. But even this might not be a problem, since it would make the position a useful hedge in portfolios that have fared well in 2017.

“We’d expect other exposures in the portfolio to perform well under this ’status quo’,” they wrote.

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