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The Unintended Consequence of Open-Ended QE


A look at the rising risk of actual volatility.

In addition to the volatility that each data point will bring, investors will also be faced with the conflicting implications open-ended QE will have on inflation discounts. Softer data will, in theory, bring about more QE, yet it will also increase inflation discounts in the market. Weak data would then be net/net bearish for the curve and thus long term duration while the opposite would be true for stronger data. I think you saw some of that in Thursday's response to the weak data. The supply demand dynamics in the mortgage market are thus now subject to inflationary discounts in not only the slope of the yield curve but also the currency and commodity markets.

This interest rate volatility will only be magnified by the ever present reflexive feedback relationship between Treasuries and MBS. As I explained in Explaining Irrational Behavior: It's a Reflexive Process:
Because the borrower has the right to prepay his mortgage at any time the mortgage holder is effectively short a call option. Because you are short this call, mortgage securities exhibit what is known as negative convexity. For this reason when you are long an MBS you are short interest rate volatility. Convexity and its derivative cousin gamma have exponential effects on market price and is a major contributor to extreme market movements.
To hedge against this negative convexity, mortgage holders will calibrate this changing duration risk with Treasuries (typically 10YRs). When yields fall they buy treasuries to add duration and sell when yields rise to reduce duration. You can see that in extreme situations (like record low Treasury yields) mortgage holders can exacerbate movements in the market as they increase demand when prices rise further pushing them higher and vice versa. They can get caught in a feedback loop so to speak.

This reflexive relationship is intensified by the Fed's influence. Consider the fact that due to the amortizing of principal in MBS, the more the Fed buys, the lower rates fall and the faster mortgages will prepay. Therefore in order to maintain the size of the balance sheet, the Fed will have to buy more MBS. Lower interest rates or higher prices will create more demand from the Fed, which is the essence of reflexivity. It also cuts both ways. If rates start to rise, the MBS in the Fed's portfolio will pay principal slower, which will reduce the need to buy more MBS to maintain the size of the balance sheet, which may drive rates higher.
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