U.S. mortgage hedging adds pressure to Treasury market as yields surge

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Mortgage hedging impacts Treasuries

Highlights

Benchmark 10-year Treasury yields surged about 130 basis points and 30-year yields rose 100 basis points since late February, driving 30-year mortgage rates to 7.4%.
Eris SOFR Swap Futures daily volume hit consecutive records ahead of the Fed's September 16 meeting, with open interest reaching a record 866,768 contracts on September 21, more than double a year earlier.
Mortgage-backed securities underperformed Treasuries by 96 basis points in September, with spreads widening 13 basis points to 125 basis points; analysts see diminishing hedging impact if rates stabilize.

Mortgage hedging flows build as rates rise

As reported by Reuters, benchmark 10-year Treasury yields have surged about 130 basis points and 30-year yields have climbed 100 basis points since late February, driven by an oil-price spike linked to war and by expectations for multiple Federal Reserve rate hikes over the next 12 months.

The move has pushed 30-year mortgage rates to a nearly three-year high of 7.4%, leaving many homeowners locked into existing loans instead of refinancing. As rates rise, the expected life of mortgage-backed securities extends, making them more sensitive to further yield moves and prompting investors to hedge that exposure through Treasury futures sales or interest rate swaps.

Mike Riddle, chief executive officer of Eris Innovations, said the market is carrying a substantial group of mortgages originated over the past three years at coupons relatively close to current mortgage rates. He said that if mortgage rates continue to climb and the prospect of further policy tightening remains, the expected duration of those loans can respond meaningfully to the next substantial move in rates, likely requiring additional hedging and adding selling pressure in Treasuries.

Evidence of that activity has appeared across rates markets in recent weeks. By the first week of October, nine megablock trades had been executed in CME-listed Eris swap futures linked to the Secured Overnight Financing Rate, each with at least $200,000 of exposure to a 1 basis-point move in interest rates, according to Riddle. Daily volume in Eris SOFR Swap Futures also reached consecutive records ahead of the Federal Reserve's September 16 policy meeting, while open interest rose to a record 866,768 contracts on September 21, more than double the previous year's levels.

Market impact appears smaller than in past selloffs

The activity is drawing attention because convexity hedging has often reinforced bond market selloffs. Analysts said the sharp underperformance of mortgage-backed securities and the widening of mortgage spreads are consistent with increased hedging, particularly when mortgages perform much worse than Treasuries during rapid rate increases.

A recent research note from Annaly Capital Management said mortgage-backed securities underperformed Treasuries with comparable duration by 96 basis points in September, their weakest monthly showing since the banking turmoil of March 2023. AGNC Investment Corp. said spreads between mortgage-backed securities and Treasuries widened by about 13 basis points in September to 125 basis points, a sign that mortgages sold off more heavily than government bonds.

Even so, analysts said the contribution of these flows to the broader rise in yields remains uncertain and may diminish as more mortgages become deeply out of the money. Amrut Nashikkar, head of derivatives strategy at Barclays, said that as more of the mortgage-backed securities universe loses refinancing incentive and prepayment risk, further selloffs become less destabilizing.

Neil Sun, a portfolio manager at BlueBay Asset Management, said the largest wave of selling pressure may already be passing if rates stabilize near current levels. Analysts also said the mortgage market is no longer large enough to exert the same influence on Treasury yields that it once did, with U.S. Bank's James Wang noting that it is far smaller than the market that amplified bond swings before the 2008 financial crisis.

Major U.S. bank earnings and the options market’s implied post-results moves were the focus of our earlier coverage, highlighting investor uncertainty about how higher rates and growing consumer strain could affect the sector. We noted that implied swings varied widely across lenders, keeping attention on whether elevated rates still support net interest margins or start to pressure borrowers and credit quality as reporting season begins.

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