Bloomberg News

Treasuries Fall on Speculation of Mortgage-Related Hedge Sales

June 11, 2013

San Francisco Fed President John Williams

San Francisco Fed President John Williams said last week a “modest adjustment downward” in the buying is possible as “early as this summer.” Photographer: Tony Avelar/Bloomberg

Treasuries dropped on concern the biggest monthly surge in yields since December will prompt investors to sell government debt as a hedge against losses on mortgage bonds as borrowing costs climb to a 14-month high.

Yields on the 10-year note, a benchmark for mortgage and corporate loans, rose for a third day on the risk the increase will lead to an even bigger surge as investors place bearish bets to protect against housing-debt losses triggered by rising rates, a practice known as convexity hedging. San Francisco Federal Reserve Bank President John Williams said last week a “modest adjustment downward” in the Fed’s bond buying is possible as “early as this summer.” The U.S. will sell $32 billion of three-year debt today.

It’s the “liquidation of mortgage paper, which needs to be hedged because of convexity fears,” said Thomas di Galoma, senior vice president of fixed-income rates trading at ED&F Man Capital Markets in New York. “People need to hedge out risk. That’s where the selling pressure is coming from.”

The 10-year yield increased four basis points, or 0.04 percentage point, to 2.25 percent at 9:54 a.m. in New York, according to Bloomberg Bond Trader prices. It reached 2.29 percent, the highest since April 4, 2012. The price of the 1.75 percent note due in May 2023 fell 10/32, or $3.13 per $1,000 face amount, to 95 19/32.

Treasury Auctions

The Treasury is selling $66 billion of securities this week in the auctions, starting with the offering of three-year notes today. The government will auction $21 billion of 10-year notes tomorrow and $13 billion of 30-year debt on June 13.

At the last three-year note sale on May 7, the bid-to-cover ratio, which gauges demand by comparing total bids with the amount of securities offered, was 3.38, versus 3.24 in April.

The 30-year bond pared losses today after its yield climbed to 3.43 percent, the highest since April 2012. The yield trimmed its increase to 3.38 percent, up one basis point.

“As some of these risk assets are sold, it should aid the bid in Treasuries,” said Justin Lederer, an interest-rate strategist at Cantor Fitzgerald LP in New York, one of 21 primary dealers that are obligated to bid in U.S. debt auctions. “There’s a little anxiety with 10s and bonds” because the auctions follow an increase in yields in the past month.

Ten-year yields may climb to 2.40 percent and then 2.75 percent if there’s a “decisive close” above key resistance at 2.23 percent, according to primary dealer Societe Generale SA.

‘Sharp’ Swings

“The primary uptrend is slowly building, but it will certainly be marked by sharp up and down swings,” analysts at the company including Ciaran O’Hagan, head of European rates strategy in Paris, wrote today in a note to clients.

The market should get used to Treasury 10-year yields rising toward 4 percent, former Goldman Sachs Asset Management Chairman Jim O’Neill said in a Bloomberg Television interview.

“If the U.S. is returning to normality, which I have suspected for a while it is, and the Fed starts to change its own view about that then at some point we have to get used to the notion of U.S. bonds being closer to 4 percent than 2,” O’Neill said.

The Fed buys $85 billion of government and mortgage securities a month to put downward pressure on borrowing costs. Treasuries fell for the past six weeks, their longest run of weekly losses since May 2009, amid speculation the central bank will taper the purchases. Ten-year yields have risen from 1.61 percent on May 1, the lowest this year.

‘Adds Pressure’

“Some people are probably concerned that Treasury yields are approaching a level that would trigger convexity hedging, which will push yields even higher,” said Soeren Moerch, head of fixed-income trading at Danske Bank S/A in Copenhagen. “That adds pressure to the market.”

As rates increase, the potential for refinancing mortgage bonds and loan-servicing drops, extending the average lives of the securities and leaving holders more vulnerable to losses.

Investors then may seek to pare the duration risk or rebalance existing hedges by selling longer-dated Treasuries, mortgage bonds or transacting in interest-rate swaps or options on those contracts, sending yields higher and spreads wider.

Dealers from Deutsche Bank AG to Barclays Plc said the risk of that happening was reduced by the fact the Fed currently has $1.2 trillion of mortgage-backed securities in its stockpile, making it the biggest holder of the securities.

“The actual convexity hedging flows will be less when rates rise this time than it was in the past,” said Dominic Konstam, global head of interest-rates research at Deutsche Bank. The hedging “was massive in 2003, and we won’t see a repeat of that. With the Fed holding so much of the mortgage paper, it really knocks down the amount of mortgage hedging needed when yields rise.”

BOJ, ECB

The Bank of Japan announced in April a plan to buy more than 7 trillion yen ($72.3 billion) of government debt a month. The BOJ finished a meeting today by keeping policy unchanged.

The European Central Bank refrained from announcing additional stimulus measures after its meeting June 6 even as it held its benchmark interest rate at 0.5 percent.

Fed Bank of St. Louis President James Bullard said yesterday inflation below the central bank’s 2 percent target may warrant prolonging the “aggressive” use of bond buying. Price gains as measured by the personal consumption expenditures price index rose 0.7 percent in April from a year earlier.

The yield difference between 10-year inflation-linked Treasuries and comparable non-indexed notes showed investors have cut expectations for consumer price increases to the lowest level in almost a year. The gap, known as the 10-year break-even rate, shrank to 2.07 percentage points today, the least since July 2012.

To contact the reporters on this story: Daniel Kruger in New York at dkruger1@bloomberg.net; Susanne Walker in New York at swalker33@bloomberg.net;

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net


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