With the market selling off, market participants are asking whether convexity hedging would have a relatively bigger impact on the shape of the curve compared to the level of rates. In a recent report, JPMorgan Securities analysts said that although there have been flows from traditional convexity hedgers over the past month, their impact on the market has been somewhat muted and less than expected. When there are large convexity hedging-related flows, swap spreads typically widen in a sell-off while higher coupons outperform, they said.
In the near term, researchers expect convexity hedging to have more of an impact on the shape of the curve, compared to its effect on rate levels. For instance, a 50 basis point sell-off would cause the overall mortgage market to extend by about $200 billion 10-year equivalents, according to JPMorgan analysts. If rates continue to sell-off, the extension rate of the MBS market will slow, as the convexity continues to improve. However, the market duration will shift significantly out the curve, even for a parallel shift in rates. For a 50 basis points sell-off, the mortgage market will lengthen by $150 billion 10-year equivalents in the 10-year part of the curve, but shorten by $40 billion 10-year equivalents in the two-year part of the curve, they said. This shift is not only due to the market discounting the effects the mortgage market slowing, but also because of the dependence on the 10-year part of the curve as it influences forward mortgage rates. While actual flows might only be a fraction of this total amount - possibly only 15% to 20% of the mortgage market would delta-hedge these moves - the mortgage market is still likely to contribute to a curve steepening if rates rise, analysts said.
In a related report from Countrywide Securities on mortgage market convexity and hedging needs, analysts noted that some servicers employ a "macro hedge" business strategy. "For a servicer that is also a major originator, the macro hedge concept holds that, in a rising interest rate cycle, higher servicing income can act to buffer some of the effect on earnings of lower origination volumes. Thus, some servicers will tend to under-hedge," analysts said. They added that if lenders perceive that the next move higher in interest rates will stall origination volumes - such as a move that brings 30-year mortgage rates to over 7.0% and raise questions about the sustainability of a soft landing - then they would have a real incentive to under-hedge the remaining negative duration in their servicing portfolios. In this case, servicers would have less duration to sell in a move to 5.5% on the 10-year Treasury than models suggest.
At this point, analysts said, the mortgage market is running out of extension risk. In addition, given the current level of interest rates, the influence of MBS convexity trades on day-to-day bond market movements are likely to be less compared to the past several years, Countrywide researchers conclude.
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