A Tsunami, Not Just a Wave

So, how bad was the month of July for the bond market? The ten-year note yield rose by ninety-four basis points in the month of July alone. This was the biggest single month rise since 1987. What was even more impressive though was that the increase in yields in percentage terms was the biggest ever. The ninety-four basis point increase in the ten-year represented a 27% increase over the base yield of 3.50% that prevailed at the end of June. In 1987, the two one hundred basis point increases in yields in one-month came from a base of 8.50%. This represented a mere 15% increase in yields in one-month. (As an aside, the increase in rates in 1987 led to the big collapse in stocks in October and the subsequent decline in yield of two hundred basis points in one month for the ten-year note.)

 
 

So, how bad was the month of July for the bond market? The ten-year note yield rose by ninety-four basis points in the month of July alone. This was the biggest single month rise since 1987. What was even more impressive though was that the increase in yields in percentage terms was the biggest ever. The ninety-four basis point increase in the ten-year represented a 27% increase over the base yield of 3.50% that prevailed at the end of June. In 1987, the two one hundred basis point increases in yields in one-month came from a base of 8.50%. This represented a mere 15% increase in yields in one-month. (As an aside, the increase in rates in 1987 led to the big collapse in stocks in October and the subsequent decline in yield of two hundred basis points in one month for the ten-year note.)

What caused this massive move? Wall Street would like us to believe it stemmed from a significant turn-around in the economy, but that is only a partial reason at best. Most of the move was triggered by wave after wave of leveraged fund selling and mortgage related selling. We commented on the beginnings of this wave in last month’s edition, but no one could have predicted how those transactions snow-balled in a chain reaction. The leveraged fund speculators had bought treasuries during the rally with very cheap borrowed money. Many of these international traders borrowed money in Japan to buy the treasuries. They used these borrowed funds to build huge positions in treasuries to earn the “carry”. The carry is the difference between the borrowing rate and the investment-earning rate. Thanks to the very low margins required to borrow against U.S. treasuries, these accounts can build enormous positions on very little capital. These players felt comfortable entering these trades due to the perception gleaned from Fed officials’ statements that monetary policy would remain aggressively easy. When the Fed flip-flopped on those comments in June and July, the market losses on those leveraged positions ate away the carry profitability quickly and those thin margins grew much thinner. Last week, we saw what looked suspiciously like forced liquidations of some of these positions as margin calls were made. No doubt, some of these speculators were wiped out or severely crippled by the swiftness in the reversal.

An even larger factor in the rapid increase in rates was mortgage-related selling. We’ve commented many times on this before. Many of the very big holders of mortgage-backed securities manage portfolios on a duration-matched or controlled duration gap basis. Computer programs dictate when the traders must sell treasuries to hedge against rising rates or buy treasuries to hedge against falling rates. There is little to nothing in the way of the human element or judgment. During July, the combination of leveraged selling and mortgage-related selling seemed to trigger wave after wave of these programmed sales. To give you an idea of the magnitude of the potential selling that is out there; consider the estimated value of securitized mortgage product that is managed in this manner is roughly $2.5 trillion. Fannie Mae and Freddie Mac alone own an estimated $1.4 trillion of these securities, and we know for a fact that they manage very closely to duration targets. The “inflection points” for hedging mortgage-backed securities tends to run along the lines of fifty basis point moves. As an example, as the rate of mortgages moves from 5.50% to 6.00% an inflection point is achieved. Those inflection points tend to be the ones that trigger a need for significant expected duration adjustments. Consider this, it is estimated that for every inflection point, these $2.5 trillion in mortgages would need a hedge adjustment of $300 billion! This means those portfolio managers need to sell ten-year treasuries or ten-year equivalents to equal $300 billion. It’s clear that the entire $2.5 trillion is not being dealt with in this manner, or there would be no bottom in the bond market. But, it’s also clear that this has been the biggest factor in the performance of the bond market for the last couple of months.

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The information provided herein has been obtained from sources believed to be reliable but is not necessarily complete and cannot be guaranteed. The opinions and estimates expressed reflect our judgement at this date and are subject to change without notice. This document is not a solicitation of any transaction in any securities referred.

 

 

 

Aug. 11, 2003


Comments

 
 
 
  • Very complex issue.
    Anonymous
     
     
     
  • Great insight.
    Anonymous
     
     
     
  • Very Knowledgebale commentary
    Anonymous