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Tuesday, June 11, 2013 2:47 PM

Mortgage Refis Plunge Following 76 Basis Point Rise in 30-Year Rate; Treasury Yield Reaches 14-Month High; What About Convexity Hedging?

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Curve Watchers Anonymous has been watching the rise in interest rates across much of the yield curve.

Yield Curve as of 2013-06-11

click on chart for sharper image

As one should suspect, mortgage rates have been rising in conjunction with the rise in treasury rates. Here is a chart from Steen Jakobsen, Chief economist at Saxo Bank in Denmark.

Note the annotation "30 Yr mortgages rate is up 76 basis points on the year with no growth increase". the phrase "no growth" pertains to lack of growth in the overall US economy.

BankRate notes the following 3-month trends.

30-Year Mortgage Rate

15-Year Mortgage Rate

5/1 ARM Mortgage Rate

As one might suspect this rapid rise in mortgage rates will wreak havoc on mortgage refinancing. And it did. I called a couple of my industry contacts and they state refinancings have plunged by 50% or more.

One contact says there has been spillover into new home applications, another has not seen that "yet".

Word About Convexity

As rates rise, three things happen.

  1. Refinancings plunge
  2. Losses mount
  3. Hedging increases

Bloomberg discusses convexity hedging in its report Treasury Yield Reaches 14-Month High.
Convexity Hedging

“Some people are probably concerned that Treasury yields are approaching a level that would trigger convexity hedging, which will push yields even higher,” said Soeren Moerch, head of fixed-income trading at Danske Bank S/A in Copenhagen. “That adds pressure to the market.”

As rates increase, the potential for refinancing mortgage bonds and loan-servicing drops, extending the average lives of the securities and leaving holders more vulnerable to losses.

Investors then may seek to pare the duration risk or rebalance existing hedges by selling longer-dated Treasuries, mortgage bonds or transacting in interest-rate swaps or options on those contracts, sending yields higher and spreads wider.

Dealers from Deutsche Bank AG to Barclays Plc said the risk of that happening was reduced by the fact the Fed currently has $1.2 trillion of mortgage-backed securities in its stockpile, making it the biggest holder of the securities.
No Repeat

“The actual convexity hedging flows will be less when rates rise this time than it was in the past,” said Dominic Konstam, global head of interest-rates research at Deutsche Bank. The hedging “was massive in 2003, and we won’t see a repeat of that. With the Fed holding so much of the mortgage paper, it really knocks down the amount of mortgage hedging needed when yields rise.”
Convexity hedging "may not" kick in, "as much" but the Fed is buying massive amounts of treasuries,  yet treasury yields soared, with mortgage rates up a very significant 76 basis points in little over a month.

Mike "Mish" Shedlock

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