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Convexity hedging drives the markets

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.

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