Selling in the market last month made US mortgage bonds the cheapest they have been for three years. During previous sell-offs, commentators have blamed the convexity trade, but this time the reasons for the pressure on the market look more complex.
The convexity trade played a major part in the mortgage sell-offs in 2001 and 2003, as investors repositioned their portfolios. The trade occurs because, when the market sells
off, the duration of the loan pool increases, forcing mortgage investors to sell their unwanted duration, which can result in the bonds selling off even more. This played some part in the November sell-off but, as the mortgage market is very long in duration already, analysts and traders think other major pressures are involved.
Traders think many traditional buyers in the mortgage market are staying away. “The GSEs, which have been massive buyers in the past, are not being so aggressive, and non-US investors are taking pause,” says Kevin White, managing director and global head of securitized product syndicate at Lehman Brothers.
Fannie Mae, for example, has been selling all this year to meet its new capital guidelines. And with the curve so flat, banks are not buying either. “Banks are not participating in agency mortgages because there’s no carry trade to make it worth it. So there’s really not the money there to support it. Instead, they’re buying into whole loans,” says another co-head of structured products trading in New York.
There had been some speculation that the reason for so much pressure on the market is that at the moment dealers are very long on spread product, and particularly mortgage bonds, so selling in the market has an exaggerated impact. Some analysts say that dealers were left holding the longer-duration, lower-coupon mortgages that no one else wanted, which they were then either trying to offload or hedging in the swap market, accounting for widening spreads in the swap market too.
White is sceptical about whether, even if this was going on, it could have much influence. “The amount of inventory dealers carry is not going to move an $8 trillion market, particularly when you think that central banks buy mortgage bonds in billion-dollar clips,” he says.
However, the sell-off in mortgages has allowed some new investors to look at the asset class. “We’re starting to see mortgages selling off more than treasuries, so opportunistic buyers are coming in, on the bet that the Fed has overdone it and won’t continue its rate hike,” says White.
Hedge funds, as well as some new money managers, have come into the market since the beginning of November. “The selling has abated and we’re seeing more smart money buyers. But it’s unlikely that there’s going to be a massive rally in December. The direction of the market is still uncertain,” says the New York co-head.
He cannot see a big upturn before the end of the year. “It’s possible traders for whom December is the first month of the fiscal year might take some aggressive positions in the market, but I can’t see the market outperforming in any significant way. The latest rally of the last two or three days [in late November] isn’t sustainable.”