Today’s article will be brief (some might say blessedly so). The topic is the publication of an article on the NY Fed’s blog entitled “Convexity Event Risks in a Rising Interest Rate Environment.”
Long-time readers may recall that I wrote an article last year, with 10-year notes at 2.12%, called “Bonds and the ‘Convexity Trade’,” in which I commented that “the bond market is very vulnerable to a convexity trade to higher yields…the recent move to new high yields for the last 12 months could trigger such a phenomenon. If it does, then we will see 10-year note rates above 3% in fairly short order.” Within a few weeks, 10-year note yields hit 2.60% and eventually topped out at 3%.
Now, the Fed tells me that this selloff was “more gradual and therefore inconsistent with a sell-off driven primarily by convexity hedging.” I suppose in a way I can agree. The sell-off was primarily driven by the fact that the Fed had abused the hell out of the bond market and pushed it to unsustainable levels. But I don’t think that’s what they’re saying.
Indeed, the Fed is actually claiming credit for the fact that the selloff was only 140bps. You see, the reason that we didn’t get a convexity-based selloff – or at least, we only got the one, and not the one I was really concerned about, on a push over 3% – is because the Fed had bought so many mortgage-backed securities that there weren’t enough current-coupon MBS left to cause a debacle!
How wonderfully serendipitous it is that even the most egregious failures of the Federal Reserve turn out to benefit society in heretofore unexpected ways. You will recall that one of the main reasons given by the Federal Reserve to purchase mortgages in the first place was to help unfreeze the mortgage market, and to provoke additional mortgage origination. In that, it evidently failed, for if it had succeeded then the total amount of negative convexity in public hands would not have changed very dramatically. In fact, it would have been worse since the new origination would have been current coupons and replacing higher coupons.
The real reason that the convexity-spurred selloff wasn’t worse isn’t because the Fed had taken all of the current coupon MBS out of the market, but because the Fed continued to buy even in the move to higher yields. A negative-convexity selloff has two parts: the increased demand for hedging, and the decreased supply of counterparties to take the other side as the ball gets rolling. In this case, one big buyer remained, which emboldened dealers who knew they wouldn’t be stuck “holding the bag.” That is the reason that the selloff was “only” 140bps and not worse.
However, the observation that the Fed’s policy was a failure, as it did not stimulate vast amounts of new mortgage activity, remains. It is true that there is less negative convexity in the mortgage market than there would otherwise have been in the absence of Fed buying. But that’s an indictment, not exoneration.