Bond market retracement improves the market mood

The market gets a handle on what happened yesterday

The market gets a handle on what happened yesterday
US 10-year yields are down 6 bps today after yesterday’s washout. The curve is flattening again but only modestly and that’s giving broader sentiment a lift. US equity futures are now higher after falling by 1% overnight and commodity currency buyers are dipping their toes in.
I wrote about the role of convexity hedging yesterday and that’s getting a wider airing today and helping the market get comfortable with what happened.

The forced sellers are investors in the $7 trillion mortgage-backed bond market. Their problem is that when Treasury yields — which strongly influence home-loan rates — suddenly rise sharply, many Americans lose interest in refinancing their old mortgages. A reduced stream of refinancings means mortgage-bond investors are left waiting for longer to collect payments on their investments. The longer the wait, the more financial pain they feel as they watch market rates climb higher without being able to take advantage of them.

Their answer: unload the Treasury bonds they hold with long maturities or adjust derivatives positions — a phenomenon known as convexity hedging — to compensate for the unexpected jump in duration on their mortgage portfolios. The extra selling just as the market is already weakening has a history of exacerbating upward moves in Treasury yields — including during major “convexity events” in 1994 and 2003.

On top of that, the soft auction and strong (inadvertent) dealer takedown led to some dumping of Treasuries in the belly.

The whole move looks a bit like a washout but it’s a delicate situation. There will be more convexity hedging and the market will have to swallow that, perhaps with foreign flows balancing it. If the bond market starts to tilt again, it will take everything with it.