Bloomberg discusses convexity hedging in its report Treasury Yield Reaches 14-Month High.
“Some people are probably concerned that Treasury yields are approaching a level that would trigger convexity hedging, which will push yields even higher,” said Soeren Moerch, head of fixed-income trading at Danske Bank S/A in Copenhagen. “That adds pressure to the market.”
As rates increase, the potential for refinancing mortgage bonds and loan-servicing drops, extending the average lives of the securities and leaving holders more vulnerable to losses.
Investors then may seek to pare the duration risk or rebalance existing hedges by selling longer-dated Treasuries, mortgage bonds or transacting in interest-rate swaps or options on those contracts, sending yields higher and spreads wider.
Dealers from Deutsche Bank AG to Barclays Plc said the risk of that happening was reduced by the fact the Fed currently has $1.2 trillion of mortgage-backed securities in its stockpile, making it the biggest holder of the securities.
“The actual convexity hedging flows will be less when rates rise this time than it was in the past,” said Dominic Konstam, global head of interest-rates research at Deutsche Bank. The hedging “was massive in 2003, and we won’t see a repeat of that. With the Fed holding so much of the mortgage paper, it really knocks down the amount of mortgage hedging needed when yields rise.”
Convexity hedging "may not" kick in, "as much" but the Fed is buying massive amounts of treasuries, yet treasury yields soared, with mortgage rates up a very significant 76 basis points in little over a month.
Mike "Mish" Shedlock
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