As outlined earlier, the US yield curve has become very steep. The steepness of the curve owes to a sharp surge in long-term yields, which were driven by improving macroeconomic figures, increasing inflation expectation, worrying refinancing needs of the US Treasury, and by mortgage market related refinancing transactions. As mortgage refinancing plays a key role for the level of interest rates (and vice versa), we have a closer look at this topic.
For the sake of simplicity imagine applying for and the bank assigning you a mortgage on the 13th of June, the day after which interest rates have started to surge dramatically.
The bank has to refinance the mortgage. If during the assignment and the refinancing period interest rates rise, financing costs for the bank rise as well. The bank has to protect itself against raising rates and needs an instrument that increases in value when interest rate increase. In order to manage interest rates risk, the bank may shorten Treasuries. This trade illustrates how mortgage markets can exert pressure on the Treasury market, as they magnify the existing up-trend in yields.
After this intuitive explanation we analyze more closely the dynamics of the bond market in order to understand better the mechanism of the mortgage market.
The relationship between bond prices and yield is not linear but convex. This means that each further decrease in yield lets the bond price rise with an increasing growth rate and vice versa. Put differently, decreasing interest rates increase the duration of common bonds and make them more price-sensitive. Given this characteristic, good news for bondholders, as they face increasing gains in price.
Understanding the convexity concept is key for mortgage market comprehension. As a matter of fact, the convexity of mortgage-backed securities (MBS) is negative meaning that when interest rates fall, the duration of MBS portfolios falls as well (opposite to normal bonds and therefore bad news for MBS holders). The negative convexity is caused by mortgage refinancing.
Between the beginning of 2001 and mid June 2003 mortgage rates have been falling continuously. This sharp decrease in rates boosted a very strong demand for mortgages and consumer loans. The consequence was boom in the housing market with upward pressure on home prices.
The prolonged fall in mortgage rates made new mortgages more attractive than old mortgages and apply for cheaper new ones. This prepayment process shortened the portfolio duration of financial institutions holding huge mortgage positions (Fannie Mae and Freddy Mac), which forced them buy long term Treasuries in order to counteract the negative convexity, increase exposure to falling rates and keep the overall portfolio duration stable.
The dynamics described above is known as the convexity trade, the direction of which changed abruptly in mid June when yields started to surge. Financial institutions involved in the mortgage market were forced to sell long-date Treasuries in order to counteract the increasing price sensitivity (duration) of their mortgage portfolio in a rising interest rates environment. Such a trading direction put pressure on the Treasury market, already suffering from rising yields.
In this context it is worth noticing that the convexity trade is not responsible for a change in the direction of interest rates, but it surely exaggerates an existing trend and increases the volatility of the bond market. When yields rise, it is difficult to say to which extent this is due to improving macroeconoic figures, rising inflation expectations or to convexity trade related transactions. However, given the past growth rate and the present huge size of the mortgage market it can be said that the impact of the convexity trade on the level of interest rates has become more important than in the past and that convexity becomes a severe problem when yields move dramatically.
(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability or completeness of the information)
- Arab News Business 15 September 2003
