Convexed | FT Alphaville


If anyone was wondering what yield curves look like at 0 per cent interest rates, Dresdner has this in a note today.

Remember that usually yield curves flatten in bear markets and steepen in bull markets — Dresdner explains:

This is due to central banks conducting monetary policy via changes of their key policy rate, a very short-term yield. Furthermore, long-run expectations with respect to growth and inflation are less volatile than short-run expectations thereof, as well leading to a higher volatility of short-end yields than their longer-run counterparts. However, as the chart below shows, once short-end yields are close to 0%, the volatility of short-end yields drops significantly (as central bank cannot cut rates below 0). In a bullish-environment, only longer-run yields can fall.

Dresdner - Japanese yield curves

The situation in the States is similar. Interest rates cannot drop much further (the effective rate is already close to zero) and the Fed has admitted to embarking on a course of quantitative easing — much like Japan in the early 2000s. In effect, short-end rates can’t drop much further, and if demand for long-term bonds keeps up (admittedly, a big if), there’ll be pressure on the yield curve to flatten instead of steepen (as Dresdner puts it, to bull-flatten instead of bull-steepen).

But, there’s something else that could intensify the pressure to flatten.

As illustrated below, US $10y swap rates have broken through the 4 per cent area for the first time since June 2003. This has implications for the mortgage market, and conversly Treasuries. Dresdner explains:

As this is likely to take mortgage rates lower, the prepayment option inherent in US mortgages will lead to a shortening of MBS portfolios (as an upcoming refinancing wave is likely) and will necessitate convexity hedging via receiving of longer-dated US$ swaps/buying of longer-dated UST. This in turn, will add to the bull-flattening pressure.

Convexity hedging, lest we forget, is a way of protecing a bond portfolio’s expected return – usually by purchases or sales of Treasuries.

To put it more simply, when interest rates fall very low, homeowners often refinance and repay their old mortgages, so owners of mortgage-backed securities (the MBS above) find their bonds are repaid faster than expected. To offset that, MBS investors have to buy long-dated assets such as 10-year Treasuries – et voila, you have a flattening yield curve.

While that would be good for homeowners, it also suggests there’d be little benefit for investors in holding longer-term US debt, other than to rebalance their portfolios, of course. And more than that, it’s a major sign of just how worried investors have become about deflation. This from the WSJ today.

The gap suggests investors expect an average annualized inflation of 0.37% over the next decade, adding to the shift over the past few months from inflation concerns to deflation worries.

Dresdner - US$ 10y swap rate