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Oh, where has all the convexity gone?

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.

On MBS, Fed needs to point to the exit

When the medication is flowing, it’s hard to see straight.

Amid the giddiness in the markets and the cheers for the end of the recession, what often gets ignored is the fact that government stimulus is still fueling the reflation of financial markets.

Yes, the U.S. government has started to retire some programs — its backing of money market funds being the most recent. But there’s still a question mark about how it plans to wind down one of its largest supports — its $1.25 trillion mortgage-backed securities purchase plan — that is due to expire at the end of the year.

Barclays risky assets move a little too cozy

Barclays has come up with an interesting way to solve an optical problem. Concerned that the bank’s shareholders are nervous about possible future writedowns of wobbly assets with a value of $12.3 billion, it has sold them to its own employees.

This isn’t necessarily a bad idea. But there are two things to dislike about this deal. First, it looks pretty cozy to sell to your own workers. And second, the deal looks potentially very favourable for the purchasers.

Nerdy thought on the Fed balance sheet

Looking quickly at the Fed balance sheet, I stumbled upon the “off balance sheet” quirk of its mortgage-backed security holdings. The Fed reports this week that its holdings through Wednesday Sept. 2 stand at $625 billion. But we know from the NY Fed data released yesterday that the central bank has bought $817.6 billion MBS so far this year.

The discrepancy, which I had forgotten but a kind source reminded me of, is because the Fed is buying mortgage pass-throughs before they settle, those purchases won’t show up right away. Here is the table that shows there are $164.7 billion MBS essentially off balance sheet. So there’s still a whole lot more coming onto the Fed’s balance sheet, even if they stopped purchasing MBS tomorrow.

Tidbits from the FOMC minutes…

Just going through the FOMC minutes now and there were a couple of interesting bits worth flagging:

Meeting participants again discussed the merits of including agency MBS backed by adjustable-rate mortgages (ARMs) in the Committee’s MBS purchase program:
Some thought it would be useful to include agency ARM MBS, noting that doing so could reduce
the unusually large spreads between ARM rates and yields on similar-duration Treasury securities—spreads that were far larger than the comparable spreads on fixed-rate mortgages; others saw little potential benefit, given the small stock and limited issuance of ARM MBS, and were hesitant to involve the Federal Reserve in another market segment. The Committee made no decision on purchasing ARM MBS at this meeting.

To buy, or not to buy MBS

It looks like the lines are being drawn within the Fed regarding its massive $1.25 trillion MBS asset purchase plan that’s due to expire at the end of the year.

New York Fed President William Dudley told CNBC earlier Monday that it’s too early to think about pulling back on these programs, and points to market expectations as a big reason the Fed should proceed carefully. The market expects the Fed to buy the full amount and is currently trying to figure out whether there’s a possibility the Fed will extend the program into next year to make for a smoother transition.

The liquidity canard

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It’s often said on Wall Street that the more liquidity there is in a given market, the better things are for investors trading stocks, bonds or commodities. And while there’s a lot of truth to that, there are times when too much liquidity can be just the wrong tonic.

After all, Wall Street’s churning-out of one subprime-mortgage backed security after another pumped a lot of liquidity into the U.S. housing market, and that simply encouraged a lot of reckless — even fraudulent — lending.

Fed MBS tally jumps to $766.6 billion

The Fed may be paring back its Treasury purchases, but its MBS program heated up this week. The central bank bought a cool $25 billion net, up nearly $5 billion from the previous week. Reuters puts the running tally now at $766.608 billion.

Running short on ammunition at the Fed?

Barring another serious economic stumble, it seems that the Fed is not going to offer much more credit easing than already planned. The minutes of the June meeting of the FOMC suggested a solid resistance to stepping up purchases of either mortgage backed securities or Treasury bonds.

On Treasuries, the committee argued that a small increase in Treasury purchases would do little to push down rates. Meanwhile a large increase could heighten fears that the Fed intended to monetize the government’s debt.

The government owns the MBS market

OK, it’s not a majority owner, but the government has an impressive stake in the $4.5 trillion agency mortgage-backed securities market.  Barclays Capital’s last count, as of July 3, puts Federal Reserve purchases at $621.6 billion since it launched the program in January.  Separately, the Treasury Department has picked up more than $145 billion since the government put Fannie Mae and Freddie Mac in receivership in September. The Treasury data is through the end of May.

The Federal Reserve has pledged to buy up to $1.25 trillion of mortgage bonds guaranteed by Fannie and Freddie and $200 billion of agency debt by year end.

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