Convexity hedging at work
A guy on Bloomberg TV a short time ago made an argument that the selling in bonds is convexity hedging, particularly in the mortgage market.
What's important to note is that it's not all bonds that are crumbling, it's the belly of the curve:
- 2s +3.5 bps to 0.158%
- 5s +16 bps to 0.763%
- 10s +10.4 bps to 1.48%
- 30s +4.7 bps to 2.28%
That quirk in the curve shows this might be a duration trade not an inflation trade or a broad puke in bonds (though there was certainly some puking today).
I don't know if we'll ever get to the bottom of it but the fact that there is an explanation that makes some sense is going to be comforting to the broader market. Market participants hate a mystery market move. If there's something that makes sense, even something as complicated as convexity hedging, then it's like a life raft for the broader market.
Another explanation that makes a lot of sense is the collapse in indirects in the 5-year sale. That left dealers with 39.8% of the takedown, the highest since 2015. Those were bonds they probably didn't want and dumped them asap, causing the spike in yields after the auction.
I think trading in the day ahead will be very tentative but the underperformance in bonds this month and solid performance in stocks (+4% in the S&P 500 MTD) will lead to some bond buying rebalancing and that could further help to calm nerves.
But before we get into tomorrow, it's could be an interesting finish today.