The end of the Federal Reserve's program to buy mortgages backed by Fannie Mae and Freddie Mac could have a ripple effect on the market for U.S. government bonds.
Once the Fed stops buying mortgage-backed securities at the end of March, private buyers will need to step in and take over in a market that the government has propped up since the financial crisis reached its peak.
But they won't want to buy MBS unless the securities offer a better return than the current rate, so mortgage rates will likely rise.
Higher rates could, in turn, spur a hedging practice in the Treasury market that has been largely absent in recent months.
As a result, longer-dated U.S. debt could cheapen and yields could climb.
A jump in yields would increase the cost of borrowing for the U.S. government.
The cost of mortgages would also rise, threatening the fragile housing recovery.
And a sharp, sudden spike in Treasury yields could spook regular government debt buyers such as foreign central banks.
Some signs in the marketplace are already pointing to this possibility.
The Treasury yield curve has steepened and the prices of bond options have risen.
"Some feel that the recent market moves reflect investor positioning for the end of several unconventional Fed facilities," said Mohamed El-Erian, co-chief investment officer at Pacific Investment Management Co., in an e-mail.
Treasury strategists have also warned that wider swings in bond prices lie ahead.
They will be driven in part by hedging practices MBS investors are known to use that the Fed, as the largest MBS buyer since the financial crisis began, did not employ.
"In essence, the Fed has taken a lot of volatility out of the marketplace," said William O'Donnell, the head of U.S. Treasury strategy at RBS Securities in Stamford, Conn.
"Any subsequent mortgage issuance is likely to fall into the hands of portfolios likely to be somewhat dynamically more hedged. It'll have the prospect and almost the certainty of adding volatility back into the rates markets."
The practice is known as convexity hedging.
Investors holding MBS can actually find themselves losing money if mortgage or interest rates rise suddenly and they cannot get rid of their lower-yielding securities.
They often try to offset unexpected increases in mortgage and interest rates by selling Treasury notes.
"If you look at option prices presently, we have the implied volatility for longer-dated options trading 25 percent over their long-term historical levels. One could argue the reason for this is that people anticipate uncertainty after March 31 end date of the Fed's MBS program," said Harley Bassman, a managing director at Bank of America Merrill Lynch.
"People are concerned about what might happen when the Fed starts to drain liquidity. This is why the volatility surface is so steep from one month to two years expiries."
Convexity hedging often feeds on itself, causing Treasury yields to rise even faster.
Ajay Rajadhyaksha, head of U.S. fixed income and securitized products research at Barclays Capital in New York, said if rates rise sharply, agency MBS could extend and trade to much longer durations.
"It is not a risk for the next 30 basis points or so in interest rates, but at a 4.10 percent (10-year) Treasury yield, the market will start to worry," he said.
Arthur Frank, director and head of MBS research at Deutsche Bank Securities in New York, said while a 4 percent Treasury yield could spark a big pick-up in convexity hedging, he noted that hedging by mortgage servicers, the banks that manage mortgage loans and collect payments from borrowers, is driven more by MBS prices.
"Servicers have varied trigger points, but it is safe to say, they might start selling mortgage duration at 99-1/2 or at 99," he said.
The Fannie Mae 30-year 4.50 percent coupon is priced at 100 8/32, with a yield of 4.438 percent.
The relationship between interest rates and MBS prepayment rates directly influences MBS pricing. More mortgage borrowers are likely to quickly pay off their old loans when interest rates are low and they can get a better deal by refinancing.
In a bond market rally, prepayment rates rise, reducing the price gains of MBS, while in a bear market, prepayment rates slow, resulting in increased price losses. This price movement is commonly referred to as "negative convexity."
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