Bond Bear Blues

Another favorite story pushed by bond apocalypse fanciers is the dreaded convexity hedging. Yes, convexity hedging in the United States adds a nasty positive feedback loop that accelerates movements and results in overshoots. However, the effects are finite, and having rates overshoot implies that rates snap back later.

The reason it occurs is that residential mortgage back securities with fixed, pre-payable loans are a major component of the U.S. fixed income market (and are not really a feature of most other fixed income markets). Households are long an option -- the mortgage is effectively callable. This has the nasty effect of reducing the effective duration when yields fall, while the duration extends when rates rise.

Entities that hold MBS versus fixed rate liabilities (either borrowing, or a fixed income benchmark) need to manage that optionality. This generates a positive feedback loop -- as has been highlighted in the Wall Street Bets shenanigans.

However, this effect only exists if large entities are delta-hedging mortgage optionality. By all accounts, the size of hedgers' balance sheets has shrunk. For example, the Federal Reserve does not delta hedge its holdings, so they effectively took a lot of nasty exposure out of the market. Rates overshoot, but that is nothing to get excited about.

Pain for Technical Analysis

Bond markets have tendency to switch between two regimes. Most of the time, they sedately trade in ranges. They then rapidly reprice to enter a new regime, possibly with an overshoot. This is the worst possible environment for traders who use technical analysis.

  • Range-trading punishes momentum strategies. As soon as a trend is identified, it turns in the other direction.
  • Rapid repricing punishes mean-reversion strategies that do well in a range-trading environment.

Next?

My bias is that structural trends towards mediocre growth and contained inflation are extremely hard to dislodge. This view could easily be described as complacent. Stories about structural changes in inflation are more plausible now than they were in past decades, but at the same time, we need to keep in mind the track record of inflation alarmism.

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Disclaimer: This article contains general discussions of economic and financial market trends for a general audience. These are not investment recommendations tailored to the particular needs of an ...

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