Interest rates are likely to be one of the factors driving the equity market this week given the release of FOMC minutes on Wednesday and the start of the Fed’s Jackson Hole Conference on Thursday.
Market chatter suggests that there is potential for convexity related selling to develop in the treasury market if the 10 year treasury breaches the 2.90% area. In layman’s terms, convexity hedging is linked to the reduced pre-payment risk on mortgage securities and the lengthening of the life of a mortgage. This activity can push rates up (reduced prepayment risk) or down (increased pre-payment risk) at certain interest rate levels.
Forecasting the direction of the treasury market is never easy, as the desire of foreign central banks to park reserves, mortgage and corporate hedging activity, and the relative performance of treasuries to other foreign debt markets can cloud the impact of inflation and economic growth on yields.
A change in leadership at the Fed is creating uncertainty and is a reason to sell first and ask questions later. The media talks about Janet Yellen and Larry Summers as leading contenders to replace Chairman Bernanke. Yellen is viewed as favorable toward QE, while Summers is less of a QE advocate. QE has played a key role in lowering marketable treasury supply and pressuring yields. It has also pressured mortgage rates.
Sentiment toward the treasury market appears negative. A recent survey by a large brokerage house suggested that only 3% of participants expected yield to be lower in a year.
Those negative the treasury market may forget that carry is starting to become interesting given the level of the fed funds rate and the strong chance the Fed will signal a desire to keep rates low for a long period.
RTI Questions: 1) What’s your view on the direction for rates into year end – where will the 10 year finish 2013? 2) Will rates derail the equity market’s rally?
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