Monday, September 9, 2013

What caused the belly of the treasury curve to become more volatile?

While yields on treasury notes and bonds have risen across the board in 2013, the jump in rates has been uneven. The 5-10-year rates - the "belly" of the curve - have increased materially more than other maturities.



Furthermore, the volatility of rates across the different maturities has also been exhibiting a similar pattern, with the yields in the belly of the curve becoming substantially more volatile.



But it hasn't always been this way. The chart below shows how the 7, 10, and 30-year volatility evolved over time.


There was an inflection period early this summer, when the 7-year yield volatility spiked above all the rest. What caused this adjustment? Some of this of course is the selloff related to the Fed's treasury holdings. With fewer purchases of certain bonds, the demand is expected to decline, pushing yields higher.

But there is another explanation. Back in June we discussed the so-called "convexity hedging" (see post). When rates began to rise, MBS durations extended, as mortgage refinancing slowed. And as rates kept increasing, higher coupon MBS became more vulnerable to extension risk. Those with a 4.75% mortgage could still refinance earlier in the summer, but the window on that mortgage closed quickly. MBS holders who saw no need to hedge in the past couple of years had to start shorting treasuries to match their increasing portfolio durations. And intermediate-term treasuries have been the choice hedging instrument. Note that a 30-year treasury is not a good hedge for a 30-year mortgage because the probability of homeowners holding on to their mortgage to maturity is quite low - a shorter instrument is therefore required.

The spike in MBS volatility early in the summer (chart below) increased hedging activity, disproportionately raising the volatility (and yields) of the belly of the treasury curve. This hedging is what created the inflection in the chart above.




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