Here's Why U.S. Bond Yields Plunged So Much Over the Past Week

(Bloomberg) -- The Federal Reserve’s surprise policy shift last week shook markets, but, even still, the intensity of the ensuing drop in U.S. bond yields has puzzled many observers. A massive wave of hedging in the swaps market helps explain the scale of the eye-catching move.

Treasuries rallied after the Fed signaled it was done raising interest rates for the moment, driving yields on 10-year notes down to levels last seen in 2017. That forced two sets of traders -- those who had bought mortgage bonds and those who had bet markets would remain calm -- to turn to derivatives markets to tweak their portfolios or stanch their losses. They snapped up positions in interest-rate swaps, pushing Treasury yields down even more.

What’s the evidence? While yields on 10-year Treasuries declined to as low as 2.35 percent on Wednesday, the rate on similar maturity swaps dropped to as little as 2.30 percent, according to data compiled by Bloomberg. The 10-year swap spread, as the gap between the two is known, had shown the swap rate at a premium for nearly all of the past year until last week. But that has now flipped to a discount and the gap has gone to a level unseen since 2017, indicating a flurry of activity in the derivatives market.

Mortgage Hedging

As bond yields fall, some home owners will look to refinance their mortgages because they can get a better deal. But that complicates things for investors in mortgage-backed bonds, because their investment strategies partly depend upon forecasting how many people will pay off their loans early.

Refinancing in effect increases the rate of prepayments. That in turn alters a key characteristic of mortgage bonds: duration, or how much their price reacts to changes in interest rates. Managers of bond investments tend to have targets for duration, so a shift can prompt some to buy interest-rate swaps in order to hit those goals. Citigroup Inc. strategist Jabaz Mathai believes that’s what happened last week when 10-year Treasury yields slipped below 2.5 percent in the wake of the Federal Open Market Committee meeting.

The sharp move in rates since the FOMC decision “can be attributed to mortgage convexity receiving hedging,” Citigroup’s head of U.S. rates strategy wrote in a March 22 report. The 10-year Treasury yield falling below 2.5 percent “likely triggered convexity flows, which is typically done by servicers, REITs and money managers,” he added.

Swap spreads have collapsed across the board, not just ones linked to 10-year Treasuries.

Low-Vol Trade Sours

Since the beginning of the year, betting that the Treasuries market would be less volatile has looked like a sure-fire way to make money. Traders were persuaded to do this by the Fed’s policy stance of being patient with further rate hikes. Bank of America Corp.’s MOVE Index, a measure of Treasury-market price swings, sank to a record low last week, evidence of just how placid traders expected the market to be.

They’d bet that tranquility would continue by selling options. But the Fed’s March 20 announcement -- a surprising shift in its stance to not just curtail rate increases, but also to probably end them completely for the moment -- stirred things up. And the MOVE gauge responded by posting its biggest two-day gain since 2016.

The Treasuries rally and resulting volatility surge quickly burned those who had sold options (see the swaption grid below), pressuring them to hedge in the swaps market by receiving fixed rates. That’s tantamount to going long Treasuries and is a profitable trade if yields keep falling. The intensity of that trading -- along with the actions of mortgage investors -- accelerated the drop in Treasury yields.

Mortgage and “hedging activity from programmatic gamma sellers is likely to keep swap spreads very directional with rate moves,” Sam Elprince, a strategist at Morgan Stanley, wrote in a March 22 report. He predicted the 10-year swap spread would continue to drop for days as hedging activity continues.

To contact the reporters on this story: Stephen Spratt in Hong Kong at sspratt3@bloomberg.net;Edward Bolingbroke in New York at ebolingbrok1@bloomberg.net;Liz Capo McCormick in New York at emccormick7@bloomberg.net

To contact the editors responsible for this story: Tan Hwee Ann at hatan@bloomberg.net, ;Benjamin Purvis at bpurvis@bloomberg.net, Nick Baker

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