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Oh, where has all the convexity gone?

October 12, 2009

The rise in U.S. Treasury yields has been very impressive considering where stocks are – the Dow is just 80 points away from 10,000 – and the improvement in economic data.  But it’s even more incredible that it happened without the aid of investors in mortgage-backed securities and mortgage servicers that typically snap up longer-dated debt like U.S. Treasuries and swaps to hedge their portfolios when interest rates fall sharply. It’s known as convexity hedging, and it was a powerful accelerator in the U.S. Treasuries market in 2002 when the Federal Reserve was pushing rates down. (It also works the other way. When rates rise suddenly, it forces mortgage investors to quickly start selling longer-dated debt.)

Deutsche Bank in a recent note says it’s been largely absent this go around, largely due to government intervention. This is important because the Fed’s exit from the agency mortgage market also means this $4.5 trillion market is likely to re-assert its influence over benchmark Treasuries. If yields are rising by then, such MBS freedom could accelerate the move. And that has an impact on mortgage rates and any other debt using Treasuries as a benchmark.

Here are DB’s reasons:

1) The Federal Reserve is the dominant force in the market. It owns 23% of the outstanding 30-yr agency market, and guess what, it doesn’t need to hedge.

2) It’s impossible to tell how much investors should be hedging since the Fed’s intervention has skewed prices too much to figure out how much risk is out there.

3) Estimates of convexity and duration risk (which is determined by when you think borrowers will refinance their mortgages) have become increasingly difficult to pinpoint since the government’s Home Affordable Refinance Program hasn’t caused a spike in prepayments yet. So those that would typically hedge are likely hunkering down.

4) Technical reasons that involve short-dated and long-dated volatilities, which I’ll leave to the experts to explain:

Fourth and finally, the change in duration has not affected the institutions that hedge their mortgage portfolios because the recent rally was accompanied by a large decline in short-dated implied volatilities (gamma) but relatively small changes in long-dated implied volatilities (vega). Thus the duration change of high-coupon mortgages was offset at least in part by the reduction in the level of gamma volatility. On the other hand, in the case of 4s and 4.5s the gamma decline had a lesser offsetting effect on the duration.

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