In the wake of Friday's better-than-expected 203,000 non-farm payroll report, the Wall Street Journal's
Jon Hilsenrath reported that with the better economic news that preceded this data, the Fed is likely to begin to scale back on its controversial $85 billion per month bond-buying program. Thus while the headlines focused on the torrid rally in stock prices, in light of this interpretation, the real story of the day was the reaction in the bond market and more specifically the mortgage-backed security (MBS) market.
The initial knee-jerk reaction in bond prices was weakness, pushing the 10-year note yield above 2.90%. That brought in talk of an inevitable test of 3.0%, the previous high met during the spring when the Fed first floated the tapering idea. The weakness was short-lived though, and despite stock prices maintaining their gains, treasuries managed to stage a curve-flattening reversal, rallying to push the 10-year yield back towards the unchanged level near 2.85%.
In light of the tapering talk, the performance of the MBS coupon stack was even more impressive. Across the board, mortgages saw interest with high coupons outperforming, as the "up in coupon" bias ruled the session. While the treasury curve ended the day largely unchanged, MBSs maintained their gains with higher coupons leading the stack, tightening against both treasuries and swaps.
The flattening bias in the coupon stack is consistent with a tapering defensive rotation. You would expect higher coupons to be in demand as investors fade the lower at-the-money "cuspy" coupons the Fed has been buying in favor of higher coupons that are less sensitive to a rise in rates. However the out-performance in higher coupons could also be a result of the November prepayment data that was released on Thursday night. This would be considered more of an offensive trade.
The following is an excerpt from the RBS Prepayment Report:
November prepayments declined more than expected with FN-30 down 10% to 11.3 CPR and FH-30 down 11% to 11.9 CPR. There are three interesting takeaways from this report: First, despite the 30bp rate rally from 4.49% in September to 4.19% in October, speeds in the belly of the stack actually fell, with 4.5s down 4% to 13 CPR. This insensitivity to relatively lower rates suggests a strong degree of burnout among cuspy coupons. Recall that mortgage rates spent the first five months of 2013 hovering around 3.5%, so borrowers were likely apathetic to these “lower” 4%-handle rate levels.
There may be a more important message from Friday's bond market price action. It seems as if the interest rate risk in the long end of the curve has diminished. The market is starting to trade like it has already discounted the Fed tapering QE. In fact, one could argue to a large degree the market has already discounted the exit from QE. How is that possible?
Most market participants operate under the assumption that US treasuries are the benchmark interest rate for which all other fixed-income securities are priced. This may be true, but it doesn’t mean treasury yields drive the market. When interest rate volatility is low, treasury yields largely lead market pricing; however, when volatility is high, the negatively convex MBS market is the tail-wagging dog.
Unlike positively convex bullet treasuries, the duration sensitivity of MBS yields is negatively convex and thus short interest rate volatility. This means that, typically, as yields fall, these securities shorten in duration as prepayments accelerate, and when yields rise, MBSs lengthen in duration as prepayments slow. Because of this negative convexity, leveraged MBS holders will buy or sell treasury duration in various instruments to hedge this risk. So as interest rate volatility rises, MBS investors can exacerbate the volatility by buying more duration as the yields fall, and selling more duration as the yields rise.
This negative convexity is responsible for the yield blowout we witnessed in May and June when tapering first began impacting market discounts. However, this time around there seems to be a different dynamic. Credit Suisse's Harley Bassman a.k.a. "the Convexity Maven"
sent out a brief note to clients on Wednesday, and not only was he spot on in his forecast for the bond market’s reaction to Friday’s NFP, but he also introduced what may be a paradigm shift in bond market dynamics (see excerpt below).
Notwithstanding that a +250k Payroll print will almost certainly pucker up the lips of the T10yr as it kisses 3.00% again, we will NOT have a replay of this summer's rate panic where Implied Volatility jumped and Actual Volatility rattled your nerves.
Why....??? Because the Convexity in the MBS market has been mostly squeezed out, as such, rates will only rise relative to their fundamentals without the flame throwing fireworks of Convexity Hedgers.
Whoa, this is big. Now I am no MBS market expert and am a modest MBS participant, however I understand interest rates and what governs market behavior. The sensitivity of MBSs to volatility is the single most important governor of bond market interest rates, and the reason is the negative convexity. If this negative convexity has been removed, then we are looking at a much different bond market composition with much less exposure to interest rate volatility. If this negative convexity has been removed, then the duration extension risk MBSs carry has also been removed, which means the securities will not be responsible for pushing interest rates higher.
This development removes a major interest rate risk factor in the long end of the curve. As Bassman states, long-term interest rates are now only subject to fundamentals. Treasury yields should now only be subject to discounts of growth and inflation. Mortgage rates are now only subject to the demand for housing credit. With longer term treasuries in between the run rate of personal consumption and nominal GDP, and current coupon MBS presenting a 70bps spread with virtually no extension risk, they now offer investors a very compelling fixed-income option.
This market has completely flip-flopped from this time last year. When the Fed launched QE III last September, committing to buy what was interpreted to be the equivalent of virtually all net new production, spreads on mortgage-backed securities collapsed. To buy a mortgage yield on top of treasuries at all-time lows meant you were selling a very expensive option for no premium. You were taking both prepayment and extension risk without compensation. You were, in effect, selling a straddle on interest rate volatility for zero.
You now have the opposite situation, where you are selling a very cheap option for a huge premium. If prepayment speeds are slowing as rates fall, then MBS duration is not shortening as it rallies. This means that yields can increase in both a rising and falling rate environment. You have virtually zero extension risk if rates rise, and a duration that doesn’t shorten if rates fall. You are now in effect receiving a premium to buy a straddle on interest rate volatility.
The consensus view of bond yields is that the risk is substantially to the upside. However these long-duration, non-negatively convex MBS assets offer investors a risk-free credit that compensates for interest rate risk in the form of extension risk that is not present. Therefore in a rising interest rate environment owners of these amortizing cash flows -- that can only get shorter than they are today -- will be able to dollar cost average up by reinvesting principal and interest into higher coupons at lower prices. This provides fixed-income investors with a unique and desirable exposure to rising interest rates.
Whereas in 2013 the MBS market was short interest rate volatility, in 2014, the MBS market is now long. It makes you wonder if -- as in 2013, when the market was short volatility and could only see volatility rise -- in 2014, a market that is long volatility can only see it fall. Despite fears of the Fed walking away from the market and an increase in volatility, it would seem the market has already adjusted and there is embedded demand behind the Fed.
Despite the lack of convexity risk in the long end of the MBS market, the emergence of convexity risk in the front end of the curve that I wrote about two weeks ago presents a different risk. In The Fed’s Guidance is Short Volatility, Based on Data That is Volatile Itself
Each data release will be an excuse for the market to recalibrate forward guidance of highly leveraged positions. The market is not going to wait around for the Fed to tell it what to do. Positions are short volatility, but more importantly, short gamma. The slightest change in economic data could elicit a massive market reaction.
If the bond market spent 2013 discounting an end to QE, it stands to reason that in 2014, the bond market will begin to discount the end of zero-interest rate policy that should end in 2015. This development could mean the curve trends higher and flatter, and a market that is now long interest rate volatility should provide support to the long end of the curve. It is not inconceivable that this time next year we will see the 5-year steeper at 2.0%, the 10-year flatter at 3.0%, and the current coupon MBS tighter at 3.25%.
Everyone is focused on the taper and it seems everyone is positioned for it. Last week, Bloomberg ran a story reporting how much banks had reduced their exposure to interest rates in order to prepare for tapering (see excerpt below).
The likelihood of higher Treasury yields as the Fed tapers may fuel more selling by banks to avoid further losses.
“The Fed talking about tapering means rates will have to go up, and banks are trying to get ahead of the move, “Marty Mosby, a bank analyst with Guggenheim Securities LLC in Hernando, Mississippi, said in a telephone interview. “No one wants to get run over once higher yields come.”
I’m not saying the bond market isn’t susceptible to rising rates and increased volatility as the Fed exits its unconventional polices; however, from where I’m sitting, the long end of the curve is well-prepared and much closer to fair value than many presume. Most of the embedded volatility in the bond market is buried in the negative convexity of MBS, and with that volatility reduced, so too is the risk of a violent move towards higher yields.