As the mortgage market is closer to being "in the money" from a refinancing perspective, Goldman Sachs notes increased negative convexity. In fact, according to the bank, mortgages are being traded with more negative convexity than models suggest (specifically for lower coupons). Goldman argues that extension is currently the dominant risk in the market.

To illustrate this, the firm examined the performance of the coupon stack since the start of 2003, looking at daily price and OAS changes as well as the corresponding yield changes.

Goldman said that mortgages having negative convexity is nothing new. What is noteworthy is that this negative convexity is currently revealed in the pattern of spread directionality in mortgages. Particularly, spreads have tended to widen more in Treasury rallies, specifically among lower coupons, versus any tightening in a Treasury sell-offs. Although there has been very little tightening on average during sell-offs, spreads have widened by approximately 7 bp per 100 bp in rallies. Not only have spreads been directional for lower coupons, but they have also widened more in rallies than they have tightened in sell-offs. This compounds the negative convexity of these coupons.

The variations in performance have several implications, said Goldman. Goldman added that lower coupons have empirically fared much more poorly compared to higher coupons in sell-offs, even on an OAS basis. Though analysts at the firm still favor a down-in-coupon bias, they would soften their views somewhat due to the recent empirical negative convexity of lower coupons. They are also hesitant to derive an empirical convexity number from their analysis, saying that estimating empirical durations is imprecise enough, and empirical convexities are even more so.

A natural place to look to hedge extension risk is the mortgage option market. But with mortgage volatility now at quite elevated levels, analysts do not recommend buying mortgage puts. Mortgage volatility is currently 10% to 30% rich relative to empirical hedge ratios, such that using the mortgage options markets to hedge would be too expensive.

However, Goldman said that the market might have settled into a new "range" trade. With the Fed expected to be on hold for quite awhile (until 2005, Goldman Sachs economists predict), and with convexity hedging potentially over for the near term, analysts think that a sharp sell-off scenario is unlikely considering the short end of the curve is anchored. But, having said that, Goldman said that a sell-off continues to represent the biggest threat to mortgages. With the hedge-adjusted carry on the sector considerably low (even lower using empirical convexity), Goldman recommends a neutral posture in mortgages.

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