The recent sell-off in U.S. Treasuries may soon be compounded thanks to banks' exposure to mortgage securities amid rising interest rates, according to the Wall Street Journal. Global bond markets have already lost trillions of dollars in value, and the prospects of economic policy under a Trump administration are for inflation and higher interest rates. This new twist with mortgage hedging may lead to even steeper losses. (For more, see: Why the Bond Market Rout may Only Get Bigger.)
Mortgage Hedging and Treasuries
Fed rate hikes and increased expectations for inflation may spur mortgage bond owners to sell Treasuries in order to reduce their exposure to rising rates, deepening the already significant bond market rout. A TD Ameritrade report suggests that the post-election bond sell-off may begin to trigger so-called "convexity hedging," in which holders of mortgage bonds sell Treasuries to reduce their exposure to rising interest rates, already amounting to around $46 billion, according to the Journal. (See also: Investor Warning: The Bond Rout May Not Be Over.)
Such convexity trades may have been a confounding factor in the lead up to the 2008 financial crisis, the Journal reports. Making matters more complicated, the historically low interest rate environment that has persisted over the past few years has given an incentive to many homeowners to refinance their mortgages to lower and lower fixed interest rates. Mortgage refinancing tends to decline as Treasury yields and mortgage rates climb. As that happens, banks and other holders of mortgage bonds find themselves with securities that will take longer to repay than expected, leaving them vulnerable to losses as interest rates rise (bind prices vary inversely to interest rates). One way to hedge against this outcome is to sell Treasuries, a short position that will offset the long position in mortgages. But, the effect therefore is further downward pressure in the market on treasuries, which in turn is a positive pressure on rates - making for a cycle of negative feedback.
The Bottom Line
Banks and other holders of mortgage securities are beginning to sell Treasuries in order to hedge their exposure to increasing interest rates, in so-called convexity hedging. Rising rates hurt the value of bonds, including mortgage bonds, so a short position in Treasuries can offset some of those losses. This selling pressure in Treasuries, however, can lead to even greater losses in the global bond market and put pressure on rates to rise even further.