Mortgage security hedging and the yield curve - includes article about call and extension risk

Federal Reserve Bank of New York - Quarterly Review, Summer-Fall, 1994 by Julia D. Fernald, Frank Keane, Patricia C. Mosser

Repo rates for particular maturities are commonly presented as spreads relative to the rate for general collateral. A high repo spread (that is, low repo rate) can be interpreted as the financing premium that a short seller must pay in order to borrow a particular maturity Treasury security overnight.

Repo spreads for the most recently issued or "on-the-run" Treasuries are shown in Chart 6.(10) Spreads for the first four months of 1994 are consistent with high demand for progressively longer dated Treasuries, presumably stemming from efforts to counteract mortgage security extension risk. Spreads widen first for five- and seven-year maturities and then for the ten-year maturities.(11)

Further evidence of increased hedging activity can be seen in Chart 7, which shows open interest in the five- and ten-year Treasury futures market from the beginning of 1994.(12) These data support the repo data: open interest increased first for the five-year contract and then for the ten-year contract as rates continued to rise.(13) Moreover, the increase in open interest for the ten-year contract corresponded closely to the high and sustained financing premium in the ten-year repo market through April.

In contrast, open interest for thirty-year bond futures shows a mild upward trend during the period (Chart 8) but no clear pattern that can be related to MBS hedging. Furthermore, it is difficult to extract information about hedging activity from movements in the open interest for the thirty-year bond contract because daily trading volume is particularly high relative to open interest.(14) The high volume reflects a high level of intraday trading and hedging, which is unlikely to be related to the MBS market.

Summary

The circumstantial evidence presented above, as well as widespread reports from market participants, suggests that shifts in mortgage security hedges and realignments of portfolios in response to longer MBS durations had a significant effect on the Treasury yield curve, particularly after the change in monetary policy direction in February 1994. Although MBS hedging certainly cannot explain all the shifts in the yield curve in early 1994, some macroeconomic evidence does support the relationship: the flattening of the ten-to thirty-year spread in early 1994 and the increased (short-run) sensitivity of long rates to changes in short rates. In addition, estimates of mortgage prepayments and durations, evidence on MBS and Treasury prices and volumes, and information from the repo and futures markets all suggest that the hedging of mortgage security extension risk was widespread and had a significant impact on the short-run movements of the Treasury market, particularly the ten-year market.

Although there is no evidence that hedging activity has affected the long-run relationship between long-term and short-term interest rates, this latest episode is further evidence that the short-run dynamics of the yield curve have changed over the last decade. As a result, the transmission of monetary policy from short-term interest rates to the real economy via long-term interest rates has probably changed as well.