Fear Isn't the Only Driver of the Treasury Rally -- Update
March 06 2020 - 09:12AM
Dow Jones News
By Julia-Ambra Verlaine
A major driver of the roaring 2020 bond-market rally is the
insatiable demand of major U.S. banks whose hedging needs have
risen with each fresh decline in rates.
Thanks to this year's bond rally, banks need to buy around $1.2
trillion of 10-year Treasury bonds to offset risks on mortgages and
bank deposits, according to J.P. Morgan research estimates.
Commercial banks own around $3 trillion of U.S. Treasury and
government-agency securities, Federal Reserve data show.
The 10-year yield, which helps set borrowing costs on everything
from home loans to business loans, has been pushed lower by worries
about the coronavirus's potential impact on the economy, which
resulted this past week in the Fed's first emergency rate cut since
the financial crisis.
The yield traded at 0.714% Friday, down from 1.90% at the
beginning of the year. The plunge both reflects and intensifies
commercial banks' efforts to manage balance-sheet risks including
sensitivity to interest-rate swings. This practice, known in
industry parlance as convexity hedging, has been a significant
factor in the bond market for years but has become even more acute
in the postcrisis era as a result of tighter rules adopted after
the 2008 crisis.
"Convexity tends to exacerbate market moves -- if rates are
going lower, convexity will make the move sharper," said Gennady
Goldberg, U.S. rates strategist at TD Bank.
Here is how it works. When interest rates fall, many homeowners
who took out fixed-rate mortgages refinance to lock in lower
monthly payments. The owners of the relevant mortgages and
mortgage-backed securities -- including the banks -- lose out on
higher payment streams. As a result of this, the prices of mortgage
bonds tend to rise less in any given bond rally than Treasury
securities or some other bonds, making them "negatively
convex."
Banks hedge their holdings of mortgages and other assets to
limit these sorts of losses, but doing so often entails buying new
assets including Treasurys. Banks also use interest-rate
derivatives to offset potential losses from changes in rates --
usually swaps, in which the bank typically exchanges the right to a
fixed payment for a floating payment under specified terms.
The sharp decline in rates is making banks even bigger buyers of
Treasurys, as the probability of mortgage refinancing increases and
they seek to bridge expected income shortfalls generated when
higher-paying fixed-income securities "prepay," as traders say when
refinancings enable a bond to be paid off early. The same dynamic
plays out to some extent with deposits, which are liabilities that
the banks seek to match with assets, a match that often comes under
pressure when the rate environment changes significantly.
The three largest U.S. banks by assets, JPMorgan Chase &
Co., Bank of America Corp. and Wells Fargo, have steadily grown
since the financial crisis, expanding their mortgage books and
raking in more consumer deposits via money-market, checking and
savings accounts. That means bigger hedges to manage risks.
JPMorgan Chase held an average of $215 billion worth of
residential mortgages on the books at the end of 2019, compared
with $143 billion a decade earlier. Wells Fargo deposits have risen
to $890 billion last year from $787 billion in 2016.
Interest-bearing deposits at Bank of America jumped nearly 20% over
the past two years to $900 billion in 2019.
In part as a result of larger mortgage and deposit balances,
both of which can require hedging, banks have grown more sensitive
to rate changes. JPMorgan research analysts estimate the expected
increase in net interest income for banks for a 1 percentage-point
rise in rates is $8 billion, up from $6 billion last year. Those
figures generally work in reverse when rates fall.
This sensitivity can be painful when banks misjudge the economic
outlook or market sentiment. In 2018 many large banks were
wrong-footed by the year-end market meltdown that ended in the
Fed's decision to begin cutting rates following several years of
increases.
The scale of these moves and the ripples from banks' efforts to
hedge them underscore the tightrope the Fed is trying to walk as it
seeks to keep the economy on track in the face of rising
coronavirus fears.
"If the Fed overreacts and cuts too much, it creates other
dynamics that hurt insurance companies, pension funds and the
banking system," said Rick Rieder, chief investment officer of
Global Fixed Income at BlackRock Inc.
Compounding the problem, banks are hamstrung by postcrisis
capital rules that have made assets like corporate bonds expensive
to hold, making it difficult for them to buy assets with long
duration they can carry on the balance sheet.
Accordingly they now are buying products long preferred by
insurance companies, including collateralized mortgage obligations
-- financially engineered mortgage bonds sold in grades that can
make higher-rated ones less vulnerable to prepayment risk -- in the
hunt for longer-lived assets that they can hold.
"This rally has exacerbated an already significant issue," said
JPMorgan's head of interest-rate derivatives research, Joshua
Younger.
Write to Julia-Ambra Verlaine at Julia.Verlaine@wsj.com
(END) Dow Jones Newswires
March 06, 2020 08:57 ET (13:57 GMT)
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