Key facts
- Investors significantly increased their positions in U.S. swap futures, indicating concern over sustained high interest rates.
- The surge in hedging activity is attributed to mortgage investors aiming to protect against extended portfolio durations caused by slower refinancing.
- Volume in Eris SOFR swap futures on Monday reached over 167,000 contracts, equivalent to approximately $16 billion, a substantial increase from average daily volumes.
- This hedging strategy involves paying fixed rates in swaps to offset potential losses on mortgage holdings as rates rise.
- Analysts believe higher long-term rates may persist due to the U.S. economy's strength and anticipated productivity boosts from AI.
Investors demonstrated significant interest in U.S. swap futures early this week, a move interpreted as a hedge against the possibility of interest rates remaining higher for a prolonged period. This surge in activity followed a sharp increase in Treasury yields.
The primary driver appears to be mortgage investors seeking protection against the risk of extended portfolio durations. When Treasury yields rise, homeowners are less likely to refinance, leading to lower prepayments and thus extending the effective life of mortgage-backed securities. To counteract this, investors typically engage in interest rate swaps or swap futures, exchanging fixed-rate payments for floating-rate ones. This strategy adds an investment that gains value as rates increase, helping to offset the price declines in their mortgage holdings.
These hedging movements are closely monitored as they can amplify bond market volatility. When rising rates extend mortgage portfolio durations, investors may sell Treasuries or increase hedges like swap futures, potentially pushing yields even higher and reinforcing the market trend.
Michael Riddle, CEO of Eris Futures, noted that while motivations behind block trades are not always known, the size and breadth of activity in Eris SOFR swap futures across various maturities could align with this mortgage hedging dynamic. He referred to the significant discussion over the past month regarding mortgage extension risk.
On Monday, volume in Eris SOFR swap futures listed on CME Group surged to over 167,000 contracts, representing approximately $16 billion in notional value. This volume was more than six times the second-quarter average daily volume of $2.5 billion and marked the eighth highest daily total in the contract's history, and the largest on a non-roll day. The interest rate risk associated with this volume was estimated at $4.5 million per basis point, equivalent to the risk of holding about $6 billion of 10-year Treasuries.
The hedging occurred after U.S. Treasury yields rose sharply last week. Former Federal Reserve Governor Kevin Warsh observed that financial conditions had already tightened considerably, with markets effectively raising both nominal and inflation-adjusted Treasury yields.
Tom Porcelli, chief U.S. economist at Wells Fargo, expressed belief that higher long-term rates are likely to persist, not due to uncontrolled inflation, but because of the U.S. economy's surprising resilience, strong corporate profit growth, and optimism that AI development will accelerate productivity.
The hedging flows on Monday were concentrated in the two-, three-, five-, and 10-year maturities, including both front-month and less liquid off-the-run contracts. Gennadiy Goldberg, head of U.S. rates strategy at TD Securities, stated that the rise in rates created significant demand for paying fixed rates from investors hedging mortgages, noting that investors often use futures first and may also pay swaps.
Over the past three years, non-bank mortgage originators have underwritten approximately $3 trillion of mortgages, many with coupons around 6-6.5%. Previously, as mortgage rates neared these levels, prepayment risk was concentrated in the shorter end of the curve, prompting hedging there. However, the recent nearly 100 basis point increase in rates, pushing mortgage rates from about 6% to around 6.6%, has significantly reduced refinancing incentives. This shift effectively pushes cash flows and risk further out the yield curve, extending portfolio duration toward the five- to 10-year sector, according to Riddle.