In the first two months of this year there has been a dramatic reconfiguration of market variables in the US, including interest rates, credit spreads and the yield curve. Both a result of and contributing to these seismic shifts in the financial landscape has been business completed by mortgage portfolios to hedge negative convexity. Dealers have been rocked on their feet by the scale of volatility buying, and the fear that if rates back up, the mortgage holders will unwind the positions and sell convexity, making any general market sell-off much more severe than would otherwise be the case.
At the beginning of December, five-year swap yields were around 6.5% while 10-year swap yields were at 6.7%. The five-year swap spread was around 105 basis points over US treasuries, and the 10-year swap spread was close to 120bp.
At the end of February, much has changed. Five-year swap yields are at least 80bp narrower at 5.7% and 10-year swap yields are 65bp lower at 6.05%. Five-year swap spreads have tightened some 20bp to 85bp, and 10-year swap spreads have come in to 95bp.
In part, these changes have been brought about by negative convexity hedging. As rates began to decline in December, holders of mortgage-based assets became aware of the danger of early pre-payment. Mortgages in the US are chiefly fixed rate, and in a declining rate environment it clearly makes sense for householders to refinance their mortgages with new, lower coupon debt.
Holders of mortgage-backed debt suddenly faced assets disappearing from their portfolio and duration shortening drastically. That’s the last thing they want in a rallying bond market. The effective duration of the mortgage index declined from 3.9 years in mid-November to 2.7 years in early January, and is now around 3.1 years, says Gerald Lucas, senior government strategist at Merrill Lynch in New York.
As there is approximately $1.9 trillion in outstanding mortgage-backed bonds, this sudden decline in duration removed a great deal of risk from the market which had to be replaced somehow. Most mortgage holders turned to the swaps market, and to a lesser extent treasuries and agencies, to buy interest rate exposure and delta hedge their negative convexity. This meant receiving fixed rate against paying floating rate in the swap market, or buying treasuries and agency debt.
Some more sophisticated mortgage accounts also used the option market. By buying short-dated receiver swaptions, holders of mortgage-backed bonds could replace the volatility that was disappearing as assets pre-paid.
However, most chose to use the swap market to put on duration in a falling rate environment. As the majority of mortgage-backed bonds are long-dated securities, the great proportion of this business was executed in the 10-year sector, and this is where swap spreads buckled under the weight of the receiving pressure. Lucas estimates that in mid-January convexity hedgers had purchased at least $60 billion of 10-year equivalents since mid-November, and that 70% of this had been done in the swaps market.
Wall Street shops were flooded by this business. No-one had ever seen anything quite like it before. At the end of January, traders estimated that the mortgage hedgers constituted between one-third and one-half of the entire dollar swap market. Though still a deep market, recent mergers have diminished its liquidity and at times it looked unable to cope with the pressure. Bids were hard to find and spreads caved in.
Of course, the fixed rate receiving, and the buying of high quality fixed income assets to replace duration only exacerbated the collapse in rates. Most mortgage accounts set key interest rate thresholds, the breach of which triggers another round of volatility buying. So the more mortgage accounts that hit 10-year bids in the swap market, the more rates came in, and the more other mortgage accounts would receive fixed, and so on.
Moreover, most swap dealers themselves hedge swap positions in the treasury market. So, as dealers paid fixed to mortgage accounts, they bought treasuries to hedge the interest rate component of the trade. Each new wave of buying threw more oil on the fire.
One key level was 6% on the 10-year swap. When swaps crashed through this level, a wave of receiving hit the market. The Fed’s first 50bp rate cut was a pivotal moment.
In the past month, rates have stabilized. Ten-year swap rates have hovered around 6% to 6.1%, and convexity-related business has tailed off. Lucas says the market is comfortable in a 5.8% to 6.2% range on the 10-year swap. “However, there will be major selling if we get above 6.2%, and major buying if we get below 5.8%. It will be considered that we have broken out of the range.”
For the first six weeks of the year, it looked as if the US was heading inexorably to lower rates. However, in the week-ending February 16, there was something of a blip. The producer price index for January came in much higher than expected at 1.1%, and there was a tremor of concern. Ten-year swap rates moved up toward 6.1% again. The market had discounted another 50bp rate cut on March 20 and at least another 25bp by the summer.
Suddenly this looked a little optimistic. Swap dealers began to worry that if rates backed up, the mortgage players would be seen in great numbers on the other side of the market looking to unwind earlier positions. This, accompanied by the selling of treasuries and agencies, would exacerbate any sell-off and drive up rates further and faster in a mirror image of what had occurred in December and January.
