What Market Forces Are Driving Long Rates Higher?

With global markets palpitating currently in a fashion all too similar to those living on the Bowery and beginning a withdrawal program, I think it is overly simplistic to say that Bernanke’s remarks last week are forcing ‘everybody out of the pool.’

What are the underlying forces at work in causing such a sharp move higher in long term rates the last 7 weeks?

While the rate on the 2 yr Treasury has moved higher by a not insignificant .2% during this time frame, the 10 year rate has moved higher by close to a full percentage point. Let’s navigate, but before addressing the forces at work, how about a cautionary comment as a preface.

While market gurus will highlight the fact that 10 year Treasury rates are up a full percentage point since early May, those with memories that go back further than that will recall that this rate bounced around 2% for the first three and a half months of calendar 2013 before lurching down to 1.6%. If the economy were improving as Fed officials have been telling us, then why did this rate go down during the last few weeks of April? That is a rhetorical question, folks.

But let’s address why the rate has spiked higher in a fashion that might be equated to the pulse of a young man on his wedding night. I would pinpoint two reasons: 1. Negative convexity 2. Let’s NOT do “the twist.”

1. What is negative convexity?

In layman’s terms, a bond that is callable as rates decline will cause it to not increase in price as much as a bond that is non-callable. In similar fashion, a bond that has this embedded call will extend — that is, trade with a longer duration — as rates move higher and bond prices decline. The US mortgage market is the market segment with which this concept of negative convexity is most widely recognized. (For those in the audience who care to dive more deeply into this concept and market segment, I welcome sharing this report).

Do you think all those homeowners who refinanced into mortgages with 3% rates plus or minus over the last few years will be in any hurry to refinance them? Not likely. Aside from people moving or otherwise paying those mortgages down or off, a large percentage of those mortgages that have been originated with these historically low rates will likely be around for a good “loooooooong” time.

That length of time impacts investors who have purchased the mortgage-backed securities in which the many billions of these mortgages reside. How so? The portfolios holding these mortgages are actually much longer — that is, have a longer duration — than what the investment managers might have initially presumed.

As investors and portfolio managers adjust the duration of their portfolios given the recent market move, they will sell — and have sold — similar long duration securities (e.g. 10 year Treasurys) to hedge their risk. Voila. This explains some of the sharp spike in the 10 year rate.

But let’s not overlook another compelling reason.

2. Let’s unwind “the twist.”

Many regular readers here will recall that in mid-2011 the Federal Reserve undertook Operation Twist in order to bring long rates down in an attempt to stimulate the economy. I heard no mention of this program in last week’s Fed statement or in Ben’s remarks BUT the market is presuming it will come to an end as the Fed tapers its QE. All stated with a few very big cautionary IF’s as a precursor (If the economy picks up, If inflation moves up… ). Back to the twist.

Bernanke undertook this program in September 2011 ( and with many market participants anticipating it) by selling short term Treasurys and purchasing long term Treasurys. Prior to undertaking this program, the spread between the 2yr Treasury rate and the 10yr Treasury averaged 2.75%.

After the Fed undertook the program, the spread ratcheted in and gyrated around a 1.5% spread. Was the Federal Reserve “overpaying” for these long term Treasurys — and were other investors similarly overpaying for other long term bonds in a speculative fashion — in an attempt to stimulate the economy? Indeed. Given Bernanke’s comments both in late May and just last week, this 2-10 spread is now normalizing and is back out to a 2.2% spread.

Other food for thought.

Whose portfolio is really taking a beating in this market selloff? The largest investor in the market over the last few years, that is, none other than the Federal Reserve itself. Ben made a cautionary point to highlight that the Fed will not sell its mortgage holdings causing an even sharper spike in rates in general and mortgage rates specifically.

What else might the Fed do or not do? Who knows.

Five years into the greatest economic crisis and central banking experiment since Moby Dick was a minnow, who truly knows how the waves on the horizon will break upon our shores.