Will there be a seismic shift in bond and agency MBS volatility as The Fed gradually raises rates and starts to unwind their massive balance sheet?
Even as the central bank amassed trillions of dollars of debt to prop up the economy following the financial crisis, it didn’t hedge its holdings or worry about gains and losses that might keep ordinary investors up at night. This extreme buy-and-hold stance has had an incredible calming effect on the bond market. Volatility has plummeted to lows rarely seen in recent memory.
But all that is now poised to change. With interest rates on the rise, analysts say the Fed could start shrinking its unprecedented $1.75 trillion position in mortgage-backed securities by year-end. That’s likely to leave more in the hands in private investors and result in increased hedging activity, a practice that has historically exacerbated swings in the Treasury market.
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“You’ll inevitably see more volatility,” said David Ader, the chief macro strategist at Informa Financial Intelligence. In 2003, a surge in “convexity hedging” triggered widespread losses in Treasuries as benchmark yields soared 1.45 percentage points in two months. Nobody is predicting anything close to a repeat. After all, the biggest hedgers back then were government-sponsored entities like Fannie Mae and Freddie Mac, which now own just a fraction of what they did and aren’t coming back.
But at a time when beleaguered bond investors are grappling with higher rates and the potential consequences of the Trump administration’s spending plans, the prospect of more volatility adds yet another thing to their list of worries.
What exactly is convexity? At its most basic, it’s a measure of a bond’s relative sensitivity to changes in interest rates.
When a bond has positive convexity, that means its price rises more than it falls when yields move. When it’s negative, like mortgage debt, its price falls more. When rates rise, hedging against convexity grows as the expected life of mortgage debt increases. That happens when refinancing slows, and tends to leave holders more vulnerable to losses.
But by protecting against those potential losses (selling Treasuries or entering into swaps contracts are two ways), traders can end up making the bond market more turbulent. That’s already starting to happen.
On March 9, analysts say hedging activity was triggered when 10-year yields hit 2.55 percent and then 2.6 percent, which in turn, pushed yields to a three-month high of 2.628 percent March 14. They slipped to 2.50 percent at 8:30 a.m. New York time Monday.
Tighter monetary policy may accelerate hedging. The Fed lift its benchmark rate a quarter-percentage point last week and signaled two more hikes this year. A few firms like RBC Capital Markets say Fed officials will start paring back their MBS re- investments as soon as the fourth quarter. (Most predict the first or second quarter of 2018.)
“This is a story that will play out over the course of a couple years,” said Jason Callan, head of structured products at Columbia Threadneedle Investments, which oversees about $500 billion. “This won’t be a big bang type effect, yet there is certainly reticence in the marketplace as to when the Fed’s reinvestment announcement will happen and what it will look like.”
Minneapolis Fed President Neel Kashkari, the only official to vote against this month’s rate hike, added new urgency to the discussion when he said last week that he would prefer the central bank announce a plan that explains how and when it will begin to reduce its balance sheet before boosting rates again.
It’s not just hedging in the MBS market that could hit Treasuries. Insurers, which have been buying protection against lower yields for years, may now do the opposite, especially if the upswing in growth and inflation continues and share prices keep rising, said Dominic Konstam, Deutsche Bank AG’s global head of rates research.
“That switch can flip if there’s a real breakout of the secular-stagnation story,” he said.
More volatility could make it harder for investors, but anypick-up in trading would be a big win for Wall Street.
Big banks, facing a profit squeeze in recent years, curtailed trading in mortgage-backed securities, and in some cases, completely exited the business. Trading desks may also see a boost as investors unwind positions they were forced into
when the Fed bought up the all MBS, according to Mark Tecotzky, co-chief investment officer of Ellington Residential.
“It will result in better profitability for banks,” said Brad Scott, head of trading at RBC Capital Markets in New York. Wall Street “will have more opportunities based on higher volatility, and there will be more participants that are likely
to enter the market.”
You can see from the following chart that Fed purchases of assets primarily focused on agency MBS in 2009/2010. Then Fed purchases of agency MBS began picking up steam again in November 2012 (aka, QE3).
As The Fed gradually raises The Fed Funds Target Rate, and The Fed begins to unwind their balance sheet, we may see a further slowing of prepayment speeds on agency MBS.
Here is Minneapolis Fed President Neel Kashkari voting against the rest of the FOMC at the latest meeting.
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