Macro Wrap-Up

Return of the Mammoths

Topics - Macroeconomics

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Return of the Mammoths

During the Pleistocene period, mammoths ruled the land. These giant pachyderms roamed the frozen prairies crushing all of the trees in their paths. Now they are long extinct, only seen as massive skeletons in museums and good-hearted curmudgeons in animated films. In bond markets, mortgage convexity hedgers are the equivalent of the mammoth. Prior to the housing bubble collapse, they allegedly trampled over other investors in the bond markets and caused enormous volatility. Any time there was a quick move in yields, you could be sure someone would cite flows from convexity hedging as the cause. But in recent years, these fixed income beasts have all but disappeared from the market dialogue and were thought to be almost extinct. During last month’s puzzling rally in bonds, mortgage convexity hedgers reemerged as a potential explanation for the magnitude of the move. 1 1 Close Bloomberg: “Here’s Why U.S. Bond Yields Plunged So Much Over the Past Week,” 3/26/19. This brings up an important question. What the hell are mortgage convexity hedgers? If you don’t want to learn some semi-technical detail about why mortgage hedging exists and how it works, you can skip the next two paragraphs, watch the Ice Age movies and then read the rest of the piece.

The story of mortgage convexity hedging goes back almost as far as the Ice Age. 2 2 Close Like the 1960s. Government Sponsored Entities (GSEs) such as Fannie Mae and Freddie Mac were created to encourage home ownership by bringing down the cost of borrowing. In practice, these GSEs buy mortgages from lenders and then package them into pools that they sell to investors, including some of the banks they bought the mortgages from in the first place. The collections of mortgages are known as mortgage-backed securities (MBS). 3 3 Close There are many different sorts of convexity hedgers, including variable annuity issuers, holders of exotic derivatives and corporate bond holders, but we’ll focus on holders of mortgage-backed securities because they are believed to have the most impact on major markets. Variable annuity hedging tends to move very specific markets, such as long dated variance. There are also plenty of moves in other products that have been attributed to Asian retail investment in various yield-plus products. Agency MBS usually offer higher yields than government bonds and can come with an implicit government guarantee on their credit. Like government bonds, MBS have exposure to changing interest rates, so many folks hedge out that exposure by either selling government bonds or more likely by doing the equivalent trade in interest rate swaps. A hedged MBS investor can earn extra yield, but there is a catch: mortgage borrowers have the option of prepaying their mortgage at almost any time. Homeowners can prepay when they relocate or they can choose to refinance when rates go down to lower their costs. 4 4 Close Their behavior is not always consistent. Some mortgage holders choose not to prepay even when rates are lower, possibly because they are unaware of lower rates or don’t want to go through all of the hassle. This creates modeling issues for MBS holders. If a mortgage in a pool prepays, the owner of the MBS gets the money from the prepayment but doesn’t get any future interest payments. In technical terms, this is known as a reduction in duration. As a result, any hedge with a government bond is imperfect. The behavior of MBS with prepayments is similar to what would happen if an option on a bond is exercised, which is why it is referred to as convexity hedging.

If some of the mortgages in a pool are prepaid, it means that investors have less future interest payments to hedge. When rates go down and people refinance, hedgers typically seek to reduce their holdings of the swap contracts. 5 5 Close The mortgage convexity buying is really “unhedging,” not hedging. It is also usually receiving fixed in swaps, but mortgage convexity unhedging receiving fixed just doesn’t sound good. Because the mortgages within a pool tend to have a similar interest rate, prepays can happen fairly quickly, so the hedgers may not have all that much time to act. Generally, swap markets are very liquid and can handle their orders, but you can imagine the potential for some very sharp moves. Liquidity has also been a concern throughout fixed income, so that could amplify their impact. 6 6 Close An additional problem is that the more rates go down the more the hedgers have to do, so it can create a self-reinforcing loop. In theory, this could go on until rates get to the point where rates are so low that most people have completed their refinancing. At that point the pools are called “seasoned” and have very little optionality left.

Prior to the financial crisis, banks and the GSEs themselves were large holders of MBS bonds. After the crisis, the GSEs reduced their mortgage holdings due to their well-publicized struggles. At around the same time, the Fed started buying MBS as part of its Quantitative Easing program. After QE3, the Fed held more than $1.7T of MBS. 7 7 Close Source: Federal Reserve. Unlike investors, the Fed does not care about the volatility of its portfolio so it does not hedge its MBS. With a large chunk of the MBS market unhedged, it’s no wonder that analysts lost interest in the topic. 8 8 Close The size of the Agency MBS market was $6.9T as of Q4 2017. Q4 2017 is when the Fed began shrinking its balance sheet and reducing its MBS holdings. Sources: SIFMA, Federal Reserve.

As part of its balance sheet normalization, the Fed has begun letting the mortgages roll off its balance sheet. More bonds will be held in the private sector and this could mean more hedging activity. Unfortunately, we don’t know what percent of private holders hedge their bonds or what their strategy for hedging is. Back in the mid 2000s, traders built sophisticated models to guess when Fannie Mae would come into the market. Generally people assume that the current hedgers are even more systematic, but since it hasn’t been all that important in a while, it may very well be that some intern, like the squeaky-voiced kid who used to work at Krusty Burger, is responsible for hedging the book. 9 9 Close “I’m sorry I forgot to update the hedge today, sir. It comes out of my bonus?? If I had a girlfriend she’d kill me” – is probably what you hear on the trading floor. Die hard Simpsons fans know his name is Jeremy Freedman. Available estimates on convexity hedging are based on unprovable assumptions about hedgers’ size and behavior. We would be cautious about those numbers, but there is some evidence that hedging may be influencing markets. During the sharp move in rates last month, swap spreads moved with rates. 10 10 Close If hedgers were executing in swap markets and pushing prices, you would see more extreme moves in swaps. This is exactly what you’d expect if MBS holders were unwinding their hedges.

If mortgage hedgers are coming back, it has some implications for price action. Because hedgers are non-economic buyers, they can move markets away from fundamentals, at least in the short run. They can also increase near-term volatility and cause quick reversals. Some economists have posited that the lack of mortgage hedging lowered volatility over the last few years, but there are plenty of other reasons volatility in fixed income might have been low. 11 11 Close Stable inflation expectations, rates pegged at or near zero and general macroeconomic stability are three that come to mind. As we have argued in many other areas, flow effects tend to be overestimated by people looking for easy explanations of market behavior. Still, mortgage hedgers should not be completely ignored. It helps to prepare for any danger, including the return of woolly mammoths. 12 12 Close Maybe some scientist will bring them back to life using DNA from frozen remains.

U.S. FOMC Minutes (Wednesday)
The Federal Reserve’s March 20th meeting had a great deal of market impact, as it solidified a significant dovish pivot. FOMC members’ forecasts for the Fed Funds rate were lowered meaningfully from a median forecast of two rate hikes in 2019 to no rate hikes. Further, the Fed announced it would end its balance sheet run off at the end of September 2019, earlier than many observers had expected. The minutes of the March FOMC meeting will be closely analyzed for further details around the Fed’s thinking about both interest rates and the long-term composition of the balance sheet. There have been a few Fed member comments recently around the balance sheet, with Boston Fed President Rosengren suggesting he would advocate for shortening the duration of Treasury holdings. This would allow the Fed room to provide further accommodation by lengthening its duration in the future. 13 13 Close Reuters: “Fed should consider holding more short-term bonds: Rosengren,” 3/25/19. Any details that tilt the scale in one direction or another could have a market impact.

European Council Brexit Summit (Wednesday)
The U.K. was originally scheduled to depart from the E.U. last week, but has been given a short extension until April 12th as politicians attempt to agree on a way forward. Prime Minister May’s Brexit roadmap has now been rejected three times in parliament, but no alternative plan has been able to command a majority. As of this writing, May has appealed to Jeremy Corbyn, leader of the opposition Labour party, to discuss a unified approach. Should this effort fall short, there could be a vote of no confidence in May’s leadership or a vote for new elections. Even if May is able to make progress, there is likely to be a need for additional time, and the Prime Minister has reportedly requested an extension of three months. This would raise thorny questions around the U.K.’s participation (or not) in upcoming E.U. elections. The European Council, an assembly of national leaders, is set to meet on Wednesday April 10th to determine the E.U.’s stance on further extensions and what conditions may be imposed on the U.K. in exchange for more time. If the decision comes down to the wire, fears of a disorderly “No Deal” Brexit could pick up once again.

China Trade Data (Friday)
Recent positive manufacturing data out of China and the U.S. may point to stabilization in international trade after the slump of 2018. Against this backdrop, trade data from China will be closely scrutinized for confirmation of improvement in Chinese and global demand. A positive import growth figure would be an encouraging sign that Chinese domestic demand is responding to recent stimulus measures. Strong export growth would assuage concerns that the global economy has lost momentum. Outside of the data, market participants will remain focused on signs of progress or setbacks in negotiations between China’s Vice Premier Liu and senior U.S. officials, the latest round of which is taking place in Washington D.C. as of this writing.

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