What Market Forces Are Driving Long Rates Higher?

With global markets currently palpitating in a fashion all too similar to those living on the Bowery and beginning a withdrawal program, I think it is overly simplistic to say that Bernanke’s remarks last week are forcing ‘everybody out of the pool.’

What are the underlying forces at work in causing such a sharp move higher in long term rates the last 7 weeks?

While the rate on the 2 yr Treasury has moved higher by a not insignificant .2% during this time frame,  the 10 year rate has moved higher by close to a full percentage point. Let’s navigate .  .  . but before addressing the forces at work, how about a cautionary comment as a preface.

While market gurus will highlight the fact that 10 year Treasury rates are up a full percentage point since early May, those with memories that go back further than that will recall that this rate bounced around 2% for the first three and a half months of calendar 2013 before lurching down to 1.6%. If the economy were improving as Fed officials have been telling us, then why did this rate go down during the last few weeks of April ? That is a rhetorical question, folks.

But let’s address why the rate has spiked higher in a fashion that might be equated to the pulse of a young man on his wedding night. I would pinpoint two reasons: 1. Negative convexity 2. Let’s NOT do “the twist.”

1. What is negative convexity?

In layman’s terms, a bond that is callable as rates decline will cause it to not increase in price as much as a bond that is non-callable. In similar fashion, a bond that has this embedded call will extend — that is, trade with a longer duration — as rates move higher and bond prices decline. The US mortgage market is the market segment with which this concept of negative convexity is most widely recognized. (For those in the audience who care to dive more deeply into this concept and market segment, I welcome sharing this report).

Do you think all those homeowners who refinanced into mortgages with 3% rates plus or minus over the last few years will be in any hurry to refinance them? Not likely. Aside from people moving or otherwise paying those mortgages down or off, a large percentage of those mortgages that have been originated with these historically low rates will likely be around for a good “loooooooong” time.

That length of time impacts investors who have purchased the mortgage-backed securities in which the many billions of these mortgages reside. How so? The portfolios holding these mortgages are actually much longer — that is, have a longer duration — than what the investment managers might have initially presumed.

As investors and portfolio managers adjust the   duration of their portfolios given the recent market move, they will sell — and have sold — similar long duration securities (e.g. 10 year Treasurys) to hedge their risk. Voila. This explains some of the sharp spike in the 10 year rate.

But let’s not overlook another compelling reason.

2. Let’s unwind “the twist.”

Many regular readers here will recall that in mid-2011 the Federal Reserve undertook Operation Twist in order to bring long rates down in an attempt to stimulate the economy. I heard no mention of this program in last week’s Fed statement or in Ben’s remarks BUT the market is presuming it will come to an end as the Fed tapers its QE. All stated with a few very big cautionary IF’s as a precursor (If the economy picks up…If inflation moves up… ). Back to the twist.

Bernanke undertook this program in September 2011 ( and with many market participants anticipating it ) by selling short term Treasurys and purchasing long term Treasurys. Prior to undertaking this program, the spread between the 2yr Treasury rate and the 10yr Treasury averaged 2.75%.

After the Fed undertook the program, the spread ratcheted in and gyrated around a 1.5% spread. Was the Federal Reserve “overpaying” for these long term Treasurys — and were other speculative investors similarly overpaying for other long term bonds —  in an attempt to stimulate the economy? Indeed. Given Bernanke’s comments both in late May and just last week, this 2-10 spread is now normalizing and is back out to a 2.2% spread.

Other food for thought.

Whose portfolio is really taking a beating in this market selloff? The largest investor in the market over the last few years, that is, none other than the Federal Reserve itself. Ben made a cautionary point to highlight that the Fed will not sell its mortgage holdings causing an even sharper spike in rates in general and mortgage rates specifically.

What else might the Fed do or not do? Who knows.

Five years into the greatest economic crisis and central banking experiment since Moby Dick was a minnow, who truly knows how the waves on the horizon will break upon our shores.

About Larry Doyle 522 Articles

Larry Doyle embarked on his Wall Street career in 1983 as a mortgage-backed securities trader for The First Boston Corporation. He was involved in the growth and development of the secondary mortgage market from its near infancy.

After close to 7 years at First Boston, Larry joined Bear Stearns in early 1990 as a mortgage trader. In 1993, Larry was named a Senior Managing Director at the firm. He left Bear to join Union Bank of Switzerland in late 1996 as Head of Mortgage Trading.

In 1998, after 15 years of trading and precipitated by Swiss Bank’s takeover of UBS, Larry moved from trading to sales as a senior salesperson at Bank of America. His move into sales led him to the role as National Sales Manager for Securitized Products at JP Morgan Chase in 2000. He was integrally involved in developing the department, hiring 40 salespeople, and generating $300 million in sales revenue. He left JP Morgan in 2006.

Throughout his career, Larry eagerly engaged clients and colleagues. He has mentored dozens of junior colleagues, recruited at a number of colleges and universities, and interviewed hundreds. He has also had extensive public speaking experience. Additionally, Larry served as Chair of the Mortgage Trading Committee for the Public Securities Association (PSA) in the mid-90s.

Larry graduated Cum Laude, Phi Beta Kappa in 1983 from the College of the Holy Cross.

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