Hi all. I have a small doubt about swap spread and mortgages hedging. If interest rates are increasing the mortgage duration is increasing so a mortgage PM is in need to pay swap. The overall effect on the swap spread is a widening. The opposite is true in case of decreasing interest rates, allowing the swap spread to narrow. My question is related to empirical evidences: why during 2003 when yield s reached multidecade lows , swap spread widened by almost 40bps because of the hedging?Is it because the mkt started selling the spread later after the tightening?Any insight is going to be really useful. Thanks everyone!

BUMP

I am not sure what time period you're referring to exactly and also your terminology. During the big 2003 rally (mid April to the low in mid June, arnd 90bps on 10y UST yield), spreads tightened arnd 15bps, which is sort of what you'd expect.In general, mtge hedging isn't the only factor that influences swap spreads.

QuoteOriginally posted by: MartinghoulI am not sure what time period you're referring to exactly and also your terminology. During the big 2003 rally (mid April to the low in mid June, arnd 90bps on 10y UST yield), spreads tightened arnd 15bps, which is sort of what you'd expect.In general, mtge hedging isn't the only factor that influences swap spreads.I was referring to summer 2003 (late july- first 10 days in August).I saw that in June, as you said, the swap spread on 10s touched the min (22bps). So, as the theory is stating, i expect a good amount of mortgage refinancing, decreasing duration and, to balance a portfolio, a swap receiver. In all of this i can confirm i saw a swap spread decrease. But what happened later in july/august? what was the driver that pushed back the spread allowing Treasuries to outperform, knowing that mortgage hedging is not the only driver of swap spreads but you may mention as well credit and exotic products hedging (i am too young to say that i lived that situation...)?Thanks again

QuoteOriginally posted by: PanoramixQuoteOriginally posted by: MartinghoulI am not sure what time period you're referring to exactly and also your terminology. During the big 2003 rally (mid April to the low in mid June, arnd 90bps on 10y UST yield), spreads tightened arnd 15bps, which is sort of what you'd expect.In general, mtge hedging isn't the only factor that influences swap spreads.I was referring to summer 2003 (late july- first 10 days in August).I saw that in June, as you said, the swap spread on 10s touched the min (22bps). So, as the theory is stating, i expect a good amount of mortgage refinancing, decreasing duration and, to balance a portfolio, a swap receiver. In all of this i can confirm i saw a swap spread decrease. But what happened later in july/august? what was the driver that pushed back the spread allowing Treasuries to outperform, knowing that mortgage hedging is not the only driver of swap spreads but you may mention as well credit and exotic products hedging (i am too young to say that i lived that situation...)?Thanks againthat was the famous or infamous "rates will stay for a long time" statement by Greenspan. I remember that going into the FOMC decision the market had been expecting a 50bp cut but Greenspan only delivered 25bp because he had been concerned about the impact on money market funds. so the bonds sold off and at the Humphrey Hawkins he made the statement that I paraphrased.edited: Also, AG had been talking about "unconventional" methods prior to the July HH testimony and then massively back-pedalled.

Ye, we had a pretty massive selloff from the mid June low, nearly 150bps. So it seems that everything moved as you'd expect, overall.

I really appreciate it.Thx Martinghoul and daveangel!

The 2003 episode was probably one of the most famous "convexity hedging" event. Here's a quote from a research note --An important technical factor driving intermediate swap spreads is mortgage convexity hedging. Mortgage duration tends to increase when rates increase. Mortgage hedgers would then offset the higher duration by paying swaps, leading to a wider swap spread. Conversely, as rates rally, mortgage durations shorten as homeowners are more likely to refinance their existing mortgage loans. Accordingly, mortgage hedgers are likely to receive fixed in order to extend the duration of their portfolios. Note that whether or not a changing MBS convexity profile would matter for the broader fixed income market depends on the ownership of these securities. To the extent that MBS assets are held by investors mimicking a benchmark, it is not a big cause for concern. But if it?s in the hands of asset/liability players who actively manage the exposures, assessing the impact of convexity hedging becomes important.Traditionally, the largest mortgage hedgers have been GSEs (and others in the mortgage industry like servicers). While these entities historically transacted in the swap and swaptions markets in large notionals, the sizes of their derivatives exposure have steadily decreased over the past few years, given the stated mandate to shrink the retained portfolios. Further, over the past few years, a significant amount of the MBS duration and convexity have been transferred to the Fed?s balance sheet, an entity that does not use swaps or options to hedge these exposures. These dynamics are likely to lessen mortgage hedging needs going forward.

QuoteOriginally posted by: haginileThe 2003 episode was probably one of the most famous "convexity hedging" event. Here's a quote from a research note --An important technical factor driving intermediate swap spreads is mortgage convexity hedging. Mortgage duration tends to increase when rates increase. Mortgage hedgers would then offset the higher duration by paying swaps, leading to a wider swap spread. Conversely, as rates rally, mortgage durations shorten as homeowners are more likely to refinance their existing mortgage loans. Accordingly, mortgage hedgers are likely to receive fixed in order to extend the duration of their portfolios. Note that whether or not a changing MBS convexity profile would matter for the broader fixed income market depends on the ownership of these securities. To the extent that MBS assets are held by investors mimicking a benchmark, it is not a big cause for concern. But if it?s in the hands of asset/liability players who actively manage the exposures, assessing the impact of convexity hedging becomes important.Traditionally, the largest mortgage hedgers have been GSEs (and others in the mortgage industry like servicers). While these entities historically transacted in the swap and swaptions markets in large notionals, the sizes of their derivatives exposure have steadily decreased over the past few years, given the stated mandate to shrink the retained portfolios. Further, over the past few years, a significant amount of the MBS duration and convexity have been transferred to the Fed?s balance sheet, an entity that does not use swaps or options to hedge these exposures. These dynamics are likely to lessen mortgage hedging needs going forward.Actually it is what i was looking at, but later i had no clues about the further widening on the swap spread. I have to admit that it is not my piece of cake and i am quite naive to US mortgage market, even though i am trying to study something about it. Many thanks to everyone.