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Qualitative Easing: Markets on the Edge of a Knife


Is convexity hedging to blame?

I got to spend some quality time with 2 of my favorite people last night: Minyan Peter and my partner Rob Roy. Since they're also 2 of the smartest people I know, the conversation is always interesting, and it's difficult to not learn something. Peter commented on the remarkable choreography of the "recovery" - from the election, to the stimulus, to the stress tests, and finally, to the transfer of risk from the government to the private sector via the recent stock and bond issuance by financial institutions like Wells Fargo (WFC), Citigroup (C) and Bank of America (BAC). Convenient, at best, we decided.

Rob asked why it was called "quantitative easing." Since none of us could exactly quantify the goals or the results, I decided that "qualitative easing" might be more appropriate.

Speaking of qualitative easing, the rates market stands on the edge of a knife. Many of you have probably been hearing about convexity hedging as one of the reasons for the accelerated pace of the rise in Treasury, swap, and mortgage rates. Convexity, or "delta" hedging is what happens when investors that hold callable, or "negatively convex" securities are forced to sell duration because as rates rise, the duration, or "interest-rate sensitivity" of their portfolio increases.

Why? Let's use a mortgage-backed security for an example. A mortgage-backed security has an embedded call feature in the form of prepayments. As people refinance, move, divorce, or die, mortgage securities receive prepayments. This is effectively a partial call that occurs every month. The dominating prepayment factor is the level of mortgage rates; the lower the mortgage rate, the more people refinance and the quicker mortgage-backed bondholders get their principal back. Conversely, as rates rise, less people will refinance and the mortgage-backed-bond cash flow becomes much longer.

Not every bondholder hedges their duration extension or delta, but enough do to have a dramatic effect on market action. In June 2003, 10-year Treasury rates bottomed out at about 3.11%. Investors sensing a top in Treasuries began to sell, and the convexity hedging took the trade nuclear. By the end of August, the 10-year was at 4.62%.

The mortgage market is currently at its most negatively convex point. This means that if rates rise from here, the duration of MBS portfolios will extend massively. How much? Some estimates of the duration equivalent of 10-year Treasuries suggest $17-19 billion of them would have to be sold to bring durations back to neutral for just a 25 basis point (.25%) rise in rates. What does that mean? Let's just say the trip from a 5.5% mortgage rate to 6% could be quick and nasty. If you thought the economy and real estate would muddle at a 4.5% mortgage rate, how's it gonna do at 6%?

I'm not sure the Fed understands the depths of the problem it's created by letting 10-year rates back up 100 basis points since March. I can't help but feel the same way I did when George W. Bush landed on the aircraft carrier and proclaimed, "Mission accomplished."

Could it really be that easy? Sure - if you think this is a normal V-shaped recovery. But if you think we've got more economic pain to come, then Ben Bernanke just made his job twice as hard: Any rally in rate space will be used to set shorts. Traders now know that the Fed can't contain rates with their current program. Anybody that partnered with the Fed has been burned and will be looking to go the other way. The market knows the inflection points for delta hedgers and will front-run them violently.

All of this would seem to spell higher rates, but how can the economic data be anything but poor with higher rates? If we breach the technically important 3.75%-3.78% area on 10s, the sell-off would be significant but most likely brief, as the overall economy would deteriorate and force people from risk back into government and agency bonds. Good luck.
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