I’ve seen it mentioned in a couple of places recently (here’s one) – the notion of negative convexity selling in the bond market.
The story goes something like this. When interest rates are low, people who have mortgages are apt to re-finance, with the opposite true when rates are higher. And for an investor who owns any of these MBS bundled products comprised of mortgages, a mixture of increasing rates and increased duration (from fewer re-fis) is very bad for asset value. The hedge is to short treasuries (i.e., “convexity selling”). And the rumor is that somewhere around 2.2% on the 10-year is where owners of these MBS bonds are going to be forced to do it in greater volume.
In the context of what’s going on lately, with respect to the talk of tapering by the Fed, if they actually did buy fewer bonds (which would cause rates to rise), at the same time that convexity selling is starting to increase, you can only imagine how much higher rates would actually go – killing any semblance of a recovery and absolutely decimating the idea that the budget deficit is shrinking.
So, it seems likely that there is no taper coming. By the way, the 10-year is right at 2.20% these days. Interesting times, indeed.
