The sell-off in Treasury bonds has sent yields racing higher over the past few weeks, and no one really seems to be sure of exactly what is driving the move.
It even caused Bill Gross, who runs the world’s biggest bond fund at PIMCO, to pitch a strange explanation for the move on CNBC yesterday: that Paul Ryan was helping to drive the latest sell-off in the bond market.
BofA fixed income strategists Priya Misra and Shyam Rajan chalk up the drop in bond prices to three main factors – relative stability in European financial markets recently, better economic data out of the United States, and mortgage originators hedging against interest rate risk now that rates have begun to rise due to the first two factors.
The strategists even identify how much each of the three factors is responsible for the sell-off in Treasuries:
Photo: BofA Merrill Lynch
According to the chart above, the first move higher in yields in late July from 1.4 per cent to 1.55 per cent was driven by decreasing tensions in the eurozone (check out that huge decrease in the spread between Spanish and German government bonds at the same time).
The second leg upward at the beginning of August from 1.55 per cent to 1.7 per cent came on the back of better than expected economic data, like the upside surprises in recent non-farm payrolls and retail sales numbers.
The latest move higher in the last two days from 1.7 per cent to 1.8 per cent was due to mortgage hedging, say the BofA strategists:
Historical lows in rates spurred mortgage refinancings which have created large pipelines. Originators would need to hedge the extension of these pipelines if rates rise. We believe that these hedging flows have been responsible for the last 10bp of the sell-off. This is evident from the cheapening in mortgage backed securities and wider swap spreads. We estimate that a 25bp increase in the primary mortgage rate extends duration of the pipelines by $25bn 10-year equivalents. Note that this is different in scale, speed and magnitude from convexity hedging, which we believe has not yet been triggered yet.
If rates continue to rise, Misra and Rajan say that the mortgage hedging effect could get bigger as more and more originators seek to hedge their portfolios, causing the sell-off to feed on itself. However, given that they don’t see the great news out of Europe and the U.S. continuing much longer, the strategists think the surge in yields will likely be halted soon.
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