Negative convexity is something which has been mentioned on this blog before.
It sounds dramatic, not to mention nerdy, but bear with us because it is something which is actually quite interesting — and something which is, once again, rearing its head in connection with the Federal Reserve.
From Bruce Krasting:
The Atlanta Fed put out a report on the status of the Fed’s purchases of MBS. The report confirms that 91% of the anticipated $1.25 Trillion of paper has been bought. This leaves about $110b of buying power left for the Fed. There is only nine weeks left until the anticipated time that this program will end. This implies an average of only $10b of intervention per week. The most recent purchase was for $16B. Look for that weekly number to fall pretty quickly from now on.
Now look at the following graph. If you print this out and check with a ruler (I did) you will see that the lowest point on the brown shaded area is 1,200 and the upper band is at 2,400 (1,200 total). The legend states that brown are both Agency Bonds and MBS. From the report you get those numbers to be Bonds = $175B and MBS = $1.14T, for a total of $1.31T. Significantly higher ($110b) than you might have expected looking at the graph. There is a simple reason for the apparent discrepancy. It is called Negative Convexity.
Unlike most bonds, which have positive convexity, mortgage bonds are said to have negative convexity since since they tend not to rise in price as much as a normal bond as interest rates decrease.
That’s because in low-interest rate environments — like now — homeowners have a tendency to prepay their mortgages; refinancing them to take advantage of the lower rates. When this happens MBS investors get a return on principal faster than they expected and they’re left to reinvest in a lower yield environment.
The pre-payment rate for the Fed’s MBS portfolio is an unknown, but Krasting has asked a mortgage-rate type to give an estimate of how quickly he thinks the Fed’s portfolio might have been been shrinking due to those prepayments. Here’s what he got back:
From this professional you get a pretty good estimate of the prepay as being 10%. That would come to $110B. This estimate goes a long way toward explaining the discrepancy between what the Fed has purchased and what the principal balance is that they currently own.
Some thoughts on this phenomenon:
-My friend suggests that going forward the prepay could be as much as 20% PA. Well that would mean something in the order of $250B over the next year. That would, by itself, be a very deflationary force. It is too big a number. It would be happening at a very bad time. Pure economics would suggest that the supply of available mortgage credit would fall sharply as a result. The Fed does not need to do repos to suck up excess reserves. They just have to collect the prepays that are coming.
-If you buy into this you have to assume that the amount of prepays in the current month will be approximately $18b (1.1T * 20% / 12). The Fed is buying $16b a week or $64b a month. So in January the net is only $46B. Follow this dotted line and you will see that by early March the purchases net of prepays will be a negative number. This will be the starting date of the true reversal of the QE process. March is much sooner than people are thinking it will occur.
-The Fed will make Net purchases totaling $1.25T. But they will never have a portfolio of that amount. It has to be less. By the numbers they will end March with approximately 1.14 – 1.16 Trillion. And the portfolio will be shrinking by $20B per month thereafter.
This is a scary thought. This could well be the basis of a back door, Sneaky Pete “QE 2.0 Lite”. If the intention were to purchase and maintain a portfolio size of $1.25T they would have to make additional purchases of $100B and continue the buys on a monthly basis of approximately $20B. This would not be a change of policy (ahem). It would be refining and maintaining the existing policy.
We’re not sure about some of those assertions. But we do think the prepayment issue throws up another problem for the Fed — one very much closer to home.
If prepayments speed up in low-interest rate scenarios, the exact opposite happens in higher-interest rate or inflationary ones. Having snapped up some $1,250bn worth of MBS, the Fed could be left to finance a significant proportion of those mortgages at interest rates higher than their yield.
In other words, if interest rates were to increase, or inflation were to pick up, the Fed would still be financing those mortgages at a cost which exceeds the yield the central bank is earning on them.
Deutsche Bank analysts put it succinctly last year:
In other words, the Fed effectively has an asset-liability mismatch. This mismatch might diminish the Fed’s ability to control inflation in the long run, as it might have to keep creating money, even if the right policy would otherwise have been to shrink the money supply.
Related links:
Hoenig the hawk – FT Alphaville
Negative convexity at the Fed – FT Alphaville
The Fed’s asset-liability mismatch – FT Alphaville
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