It was great to be a “Master of the Universe” (Treasury and MBS trader) since October 1981 when the US 10Y Treasury yield peaked at 15.84% and mortgage rates peaked at 18.63%. Treasury and mortgage rates have generally fallen ever since. But what happens if Treasury and mortgage rates rise?
![](https://wordpress-1016567-4521551.cloudwaysapps.com/wp-content/uploads/2021/10/warning-big-short-resurfaces-in-u-s-bonds-wary-of-convexity-trigger.png)
Bond investors are piling back into short positions, motivated not only by the specter of inflation but also by the risk that yields are approaching levels that will unleash a wave of new selling by convexity hedgers.
That level is around 1.60% in the U.S. 10-year Treasury yield, less than 10 basis points from its current mark, according to Brean Capital’s head of fixed income strategy, Scott Buchta. It’s the mid-point of “a key threshold” between 1.40% to 1.80%, an area “most critical from a convexity hedging point of view.”
Convexity hedging involves shedding U.S. interest-rate risk to protect the value of mortgage-backed securities as yields rise, slowing expected prepayment rates.
![](https://wordpress-1016567-4521551.cloudwaysapps.com/wp-content/uploads/2021/10/warning-big-short-resurfaces-in-u-s-bonds-wary-of-convexity-trigger-1.png)
It’s already begun to pick up as yields stretched past the 1.40% level. Another wave is expected at around 1.6% — a point of “maximum negative convexity” in agency MBS, “where 25bp rallies and sell-offs should have an equal effect on convexity-related buying and selling,” Buchta says.
![](https://wordpress-1016567-4521551.cloudwaysapps.com/wp-content/uploads/2021/10/warning-big-short-resurfaces-in-u-s-bonds-wary-of-convexity-trigger-2.png)
Signs that short positions are accumulating include Societe Generale’s “Trend Indicator.” Among its 10 newest trades are short positions in Japanese 10-year debt, German 5-year debt futures, U.K. 10-year gilts, U.K. short sterling and U.S. 2- and 5-year notes. Meanwhile, CFTC positioning data for U.S. Treasury futures show asset managers flipped to net short in 10-year note contracts in the process of dumping the equivalent of $23 million per basis point of cash Treasuries over the past week. Hedge-fund shorts also remain elevated in the long-end of the curve, as measured by net positions in Bond and Ultra Bond futures.
“Bond-bearish impulses remain in place,” says Citigroup Inc. strategist Bill O’Donnell in a note, citing tactical and medium-term set-ups. Traders should be aware of short-covering rallies in the meantime, however, he says.
“Potentially extreme short-term positioning and sentiment set-ups could easily allow for a counter-trend correction under the right conditions,” he said.
U.S. 10-year yields topped at 1.57% this week, the cheapest level since June, spurring the breakeven inflation rate for 10-year TIPS to 2.51%, the highest since May. Friday’s September jobs report could add fuel to this inflationary fire, rewarding bond shorts.
Here is a chart of the rising 10Y Treasury yield against The Fed’s 5Y forward breakeven rate.
![](https://wordpress-1016567-4521551.cloudwaysapps.com/wp-content/uploads/2021/10/warning-big-short-resurfaces-in-u-s-bonds-wary-of-convexity-trigger-3.png)
Here is a Fannie Mae 3% coupon MBS. Note the rise in Modified Duration with an increase in interest rates.
![](https://wordpress-1016567-4521551.cloudwaysapps.com/wp-content/uploads/2021/10/warning-big-short-resurfaces-in-u-s-bonds-wary-of-convexity-trigger-4.png)
Convexity for the FNMA 3% MBS?
![](https://wordpress-1016567-4521551.cloudwaysapps.com/wp-content/uploads/2021/10/warning-big-short-resurfaces-in-u-s-bonds-wary-of-convexity-trigger-5.png)
There is something on the wing. Some-thing.
![](https://wordpress-1016567-4521551.cloudwaysapps.com/wp-content/uploads/2021/10/warning-big-short-resurfaces-in-u-s-bonds-wary-of-convexity-trigger-6.png)
- among
- AREA
- around
- asset
- Bill
- Bonds
- Buying
- Cash
- CFTC
- contracts
- Current
- curve
- Debt
- Fire
- Forward
- Fuel
- Futures
- great
- head
- HTTPS
- Inc.
- Income
- Increase
- inflation
- interest
- Interest Rates
- Investors
- Jobs
- Key
- Level
- million
- Mortgage
- net
- Point of View
- protect
- Rates
- report
- Risk
- Securities
- sentiment
- Short
- shorts
- Slowing
- Strategy
- tactical
- tips
- trader
- Traders
- trades
- treasury
- U.K.
- u.s.
- Ultra
- us
- value
- View
- Wave
- week
- Wing
- WordPress
- Yield
- youtube