Alarm! Big Short Resurfaces in U.S. Bonds, Wary of ‘Convexity Trigger’

Alarm!

It was great to be a “Master of the Universe” (Treasury and MBS trader) since October 1981 when the US 10Y Treasury yield peaked at 15.84% and mortgage rates peaked at 18.63%. Treasury and mortgage rates have generally fallen ever since. But what happens if Treasury and mortgage rates rise?

Bond investors are piling back into short positions, motivated not only by the specter of inflation but also by the risk that yields are approaching levels that will unleash a wave of new selling by convexity hedgers. 

That level is around 1.60% in the U.S. 10-year Treasury yield, less than 10 basis points from its current mark, according to Brean Capital’s head of fixed income strategy, Scott Buchta. It’s the mid-point of “a key threshold” between 1.40% to 1.80%, an area “most critical from a convexity hedging point of view.”

Convexity hedging involves shedding U.S. interest-rate risk to protect the value of mortgage-backed securities as yields rise, slowing expected prepayment rates.

It’s already begun to pick up as yields stretched past the 1.40% level. Another wave is expected at around 1.6% — a point of “maximum negative convexity” in agency MBS, “where 25bp rallies and sell-offs should have an equal effect on convexity-related buying and selling,” Buchta says. 

Signs that short positions are accumulating include Societe Generale’s “Trend Indicator.” Among its 10 newest trades are short positions in Japanese 10-year debt, German 5-year debt futures, U.K. 10-year gilts, U.K. short sterling and U.S. 2- and 5-year notes. Meanwhile, CFTC positioning data for U.S. Treasury futures show asset managers flipped to net short in 10-year note contracts in the process of dumping the equivalent of $23 million per basis point of cash Treasuries over the past week. Hedge-fund shorts also remain elevated in the long-end of the curve, as measured by net positions in Bond and Ultra Bond futures. 

“Bond-bearish impulses remain in place,” says Citigroup Inc. strategist Bill O’Donnell in a note, citing tactical and medium-term set-ups. Traders should be aware of short-covering rallies in the meantime, however, he says. 

“Potentially extreme short-term positioning and sentiment set-ups could easily allow for a counter-trend correction under the right conditions,” he said.

U.S. 10-year yields topped at 1.57% this week, the cheapest level since June, spurring the breakeven inflation rate for 10-year TIPS to 2.51%, the highest since May. Friday’s September jobs report could add fuel to this inflationary fire, rewarding bond shorts. 

Here is a chart of the rising 10Y Treasury yield against The Fed’s 5Y forward breakeven rate.

Here is a Fannie Mae 3% coupon MBS. Note the rise in Modified Duration with an increase in interest rates.

Convexity for the FNMA 3% MBS?

There is something on the wing. Some-thing.

The Fed Helped Create Housing Bubble I And Then Helped Create Housing Bubble II: The Sequel (Case Study Of Phoenix AZ Home Price Bubble)

Phil Hall of Benzinga wrote a series of excellent articles in four parts for MortgageOrb (although “The Orb” has removed his name). Here are the links to his stories.

https://mortgageorb.com/the-fall-and-rise-of-the-housing-market-part-one

https://mortgageorb.com/the-fall-and-rise-of-the-housing-market-part-two

https://mortgageorb.com/the-fall-and-rise-of-the-housing-market-part-three

https://mortgageorb.com/the-fall-and-rise-of-the-housing-market-part-four

After re-reading these excellent articles on the housing bubble and crash, I thought I would take the opportunity to present a few charts to highlight the housing bubble, pre-crash and post-crash.

Here is a graph of Phoenix AZ home prices. Note the bubble that peaked in mid 2006. The Phoenix bubble correlates with the large volume of sub-620 FICO lending and Adjustable-rate mortgage (ARM) lending. Bear in mind, many of the ARMs prior to 2010 were NINJA (no income, no job) ARM loans.

What happened? Serious delinquenices at the national levels spiked as The Great Recession set in and unemployment spiked.

Since the housing bubble burst and surge in serious mortgage delinquencies, The Federal Reserve entered the economy with a vengeance. And have never left, and increased their drowning of markets with liquidity.

The Fed whip-sawing of interest rates in response to the 2001 recession was certainly a problem. They dropped The Fed Funds Target rate like a rock, then homebuilding went wild nationally and home prices soared thanks to Alt-A (NINJA) and ARM lending. But now The Fed is dominating markets like a gigantic T-Rex.

Oddly, then Fed Chair Ben Bernanke never saw the bubble coming. Or the burst.

Speaking of pizza, Donato’s from Columbus Ohio is my favorite. Founder’s Favorite is my favorite, but they do offer the dreaded Hawaiian pizza (ham, pineapple, almonds and … cinnamon?)

Bleech!