Hedging Flows Supporting Treasury Rally May Have Further to Go
Hedging Flows Supporting Treasury Rally May Have Further to Go
(Bloomberg) -- The coronavirus-fueled slide in Treasury yields may have triggered a phenomenon known as convexity hedging -- which also means there could be further downside.
The 10-year yield had held within a range of about 1.70% to 1.95% since October, before heading lower late last week as concerns about the spread of coronavirus from China sent investors searching for safe havens. The break below 1.70% on Friday appears to have spurred convexity hedging flows from a variety of market players, adding fuel to the rally, according to TD Securities. What’s more, those flows may exacerbate further declines in yields.
“We think that some convexity receiving probably occurred from mortgage investors as well as insurance (variable annuities, general accounts, and fixed index annuities),” Priya Misra, head of global rates at TD Securities, wrote in a client note.
The conditions certainly appear ripe for it to happen. Mortgage portfolios tend to bring about convexity hedging flows in interest-rate swaps when 10-year yields fall, and yields dropped more than 30 basis points from the start of the year to as low as 1.57% on Tuesday. Hedging of convexity as part of variable annuities and fixed-index annuities by insurance companies can prompt the flows as stocks fall. The S&P 500 dropped 0.9% on Friday and 1.6% on Monday before rallying 1% on Tuesday.
Additional losses may be on the way should virus fears mount, if history is a guide. The S&P 500 fell more than 8% between mid-November 2002 and early March 2003 amid the Severe Acute Respiratory Syndrome, or SARS, outbreak.
“Further risk-negative headlines could take the 10-year back to record lows of 1.35% as convexity receiving exacerbates the move,” Misra said, adding that the bank took profits on long positions as the yield hit 1.6%.
To contact the reporter on this story: Stephen Spratt in Hong Kong at sspratt3@bloomberg.net
To contact the editors responsible for this story: Tan Hwee Ann at hatan@bloomberg.net, Joanna Ossinger, Andreea Papuc
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