Mortgage hedging adds selling pressure to US Treasury market as yields surge

The sharp rise in long-term US Treasury yields has triggered mortgage-related hedging, adding selling pressure to an already strained bond market. However, the impact is likely to be smaller than during previous selloffs, according to a report by Reuters.

Benchmark 10-year Treasury yields have climbed about 130 basis points since late February, while 30-year yields have risen 100 basis points. The increase has been driven by a surge in oil prices following the war in the Middle East, fuelling expectations that the Federal Reserve could raise interest rates multiple times over the next 12 months, the report stated.

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The rise in bond yields has pushed 30-year mortgage rates to a nearly three-year high of 7.4%, discouraging homeowners from refinancing existing loans and keeping them locked into mortgages secured at lower rates.

This shift affects mortgage-backed securities (MBS), pools of home loans that generate cash flows through borrowers' monthly principal and interest payments. As interest rates rise and refinancing becomes less attractive, the expected life of these securities extends, increasing their sensitivity to further yield moves, Reuters reported.

Investors often respond by selling Treasury futures or entering interest rate swaps to hedge the additional exposure, a strategy known as convexity hedging. Such activity can amplify bond market declines by generating further selling pressure on Treasuries.

Mike Riddle, chief executive officer of Chicago-based Eris Innovations, said a substantial number of mortgages originated over the past three years carry interest rates relatively close to current mortgage rates. Further increases in borrowing costs, combined with expectations of additional monetary tightening, could significantly extend the expected duration of these loans and prompt investors to increase hedging activity, as per the report.

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Hedging Activity Gains Attention

Signs of increased hedging have emerged across interest rate markets in recent weeks, according to Reuters.

By the first week of October, nine large-block trades had been executed in CME-listed Eris SOFR Swap Futures, each carrying exposure of at least $200,000 for a one-basis-point move in interest rates, Riddle said. The transactions indicated that investors were adjusting positions in response to changes in the yield curve.

Daily trading volume in Eris SOFR Swap Futures reached consecutive records ahead of the Federal Reserve's September 16 policy meeting, including transactions positioning for an expected rate increase. Open interest, which measures the number of outstanding contracts, rose to a record 866,768 contracts on September 21, more than doubling the level recorded a year earlier.

Convexity hedging has historically reinforced bond market selloffs, making the latest activity particularly significant as Treasury yields climb.

The underperformance of mortgage-backed securities relative to government bonds and the widening of mortgage spreads have also pointed to increased hedging activity. When mortgage securities weaken more sharply than comparable-duration Treasuries during a rapid rise in interest rates, it can indicate that investors are adjusting their hedges.

According to a recent research note from Annaly Capital Management, mortgage-backed securities underperformed Treasuries with comparable duration by 96 basis points in September, marking their weakest monthly performance since the banking turmoil of March 2023.

Mortgage spreads over Treasuries also widened about 13 basis points in September to 125 basis points, according to AGNC Investment Corp., suggesting mortgage securities faced greater selling pressure than government bonds.

Impact may ease as refinancing incentives decline

Despite the signs of increased hedging, the extent to which these flows are contributing to the broader rise in Treasury yields remains uncertain.

Analysts say the impact of convexity hedging generally diminishes as interest rates rise because a growing proportion of mortgage borrowers lose the incentive to refinance. This reduces the likelihood of early loan repayments and makes mortgage-backed securities less sensitive to changes in prepayment expectations.

Amrut Nashikkar, head of derivatives strategy at Barclays, said a growing share of mortgage-backed securities was significantly out of the money, meaning borrowers had little or no financial incentive to refinance. That reduces prepayment risk and limits the potential for further rate increases to trigger destabilising hedging flows.

Neil Sun, a portfolio manager at BlueBay Asset Management, said the bulk of the selling pressure could already have occurred if interest rates stabilise around current levels.

The size of the mortgage market is another factor limiting the potential impact on Treasuries. Analysts say the sector is considerably smaller than it was before the 2008 global financial crisis, when mortgage-related hedging played a more prominent role in amplifying bond market volatility.

James Wang, head of macro at US Bank, said the mortgage market was no longer large enough to exert the same influence on Treasury yields as it did before the financial crisis.

The mortgage portfolios of government-sponsored housing enterprises Fannie Mae and Freddie Mac have contracted significantly since the crisis. Before 2008, the two institutions actively managed interest-rate risk arising from differences in the duration of their assets and liabilities, making them among the largest participants in mortgage-related hedging.

While mortgage-related hedging may be adding to the pressure on government bonds, expectations for monetary policy remain the primary driver of the latest selloff, Wang said.

The outlook for Treasury yields will therefore continue to depend largely on how oil prices, inflation expectations and the Federal Reserve's policy path evolve, even as mortgage-related trading adds another layer of volatility to the bond market, according to Reuters.

(Disclaimer: This article is based on inputs from agencies. These do not represent the views of The Economic Times)