The selloff in Treasuries accelerated as stronger-than-expected April inflation data prompted markets to reassess Federal Reserve policy expectations. Investors, who had anticipated rate cuts, are now increasingly pricing in another Fed hike this year, leading the benchmark 10-year Treasury yield to climb 23 basis points in a week and over 60 basis points since the onset of the U.S.-Israel-Iran conflict.
The rapid rise in yields has intensified "convexity hedging" activity among MBS investors, including insurance companies, mortgage REITs, and asset managers. Convexity hedging involves offsetting the changing duration risk of mortgage-backed securities as interest rates rise. MBS are highly sensitive to refinancing trends, and as rates increase, homeowners are less likely to refinance, extending the effective maturity of MBS and making them behave like longer-dated bonds.
Unlike traditional bonds, MBS exhibit negative convexity, causing their prices to decline more sharply when yields rise. This forces investors to rebalance portfolios by selling Treasury futures or other government debt instruments to reduce duration exposure. The impact of these hedging flows became particularly visible earlier this week, with unusually large block trades in Treasury futures, especially in five- and 10-year maturities.
Analysts believe the Federal Reserve’s quantitative tightening (QT) program is amplifying the effect. Under QT, the Fed allows up to $35 billion in MBS to mature monthly while reinvesting proceeds into Treasury bills, shifting mortgage-related convexity risk from the Fed’s balance sheet back into private markets.
According to market experts, today’s convexity hedging flows are becoming a larger driver of Treasury market volatility than in previous years. The growing share of higher-coupon mortgages, now exceeding $2 trillion in the MBS market, has made mortgage portfolios more sensitive to interest-rate swings.
The spike in Treasury yields has broader implications for financial markets, tightening financial conditions, increasing borrowing costs, and pressuring equity valuations, particularly in growth-oriented sectors like technology and real estate. Higher mortgage rates can also slow housing demand, impacting homebuilders, banks, and consumer spending trends.
Background
The Federal Reserve's quantitative tightening program and the growing share of higher-coupon mortgages have increased the sensitivity of mortgage portfolios to interest-rate swings, making convexity hedging a significant factor in market volatility.
As long as inflation concerns and elevated interest rates persist, analysts expect convexity-related flows to remain a significant factor in market volatility. Investors should be mindful of how technical market dynamics can amplify fixed-income market volatility.
