Bond markets experienced unusual volatility last Wednesday, with investors warning the US Treasury market has been gripped by a 'vicious loop' of selling. The primary mechanical accelerant identified is US mortgage convexity trading. Holders of US mortgage-backed securities (MBS) often must dump bonds when the market comes under pressure, effectively pouring gasoline on a bond market fire. With the agency MBS market valued at approximately $7 trillion—comparable to the entire US investment-grade corporate bond market—MBS market dynamics have significant repercussions for broader Treasury yields.
The mechanism works inversely to typical borrower benefits. While homeowners like Robert Armstrong benefit from fixed-rate mortgages, portfolio managers owning agency MBS are short prepayment risk. When Treasury yields rise, these mortgages behave like long-dated bonds, deterring refinancing. Conversely, if yields fall toward zero, mass refinancing forces MBS to dissolve into cash payouts. This structure means MBS holders bear the substantial downside of long-dated bonds in a rising rate environment, creating a feedback loop that amplifies Treasury market movements.
The US agency MBS market, primarily backed by Fannie Mae and Freddie Mac, represents a massive $7 trillion sector. This size ensures that foibles within the mortgage market do have wide-reaching repercussions for Treasury portfolios and overall market stability.
Source: Financial Times Markets · Summarized by HeadlinesBriefing