"Is The Treasury Market Wrong Because Of Hedgers?"

This is a couple weeks old but we're linking because he raises some interesting points on big picture factors in the bond market and on the Fed's balance sheet.
From Bond Economics (also on blogroll at right), August 28:

I have some seen some commentary about hedging demand and Treasury yields. One typical interpretation is that hedging demand is pushing Treasury yields "too low," and so the signal from the yield curve is distorted. Furthermore, one could argue that this represents some form of "bond bubble."

Since I do not give unsolicited investment advice to random strangers over the internet, I cannot give an answer to those questions. However, I can safely discuss the background behind these arguments, which have some merit (but are perhaps dangerous).

V-Shaped Yield Moves 

The figure at the top of this article shows the 10-year Treasury yield and the Freddie Mac 30-year conventional yield (which I just showed a few weeks earlier, but I cut down the time scale). If you look at the black line showing Treasury yields, you will see that when they hit a local bottom, they tend to violently reverse. I.e., the yield chart is "V-shaped," which means that the price peaks and then falls relatively rapidly.

This sort of peaking behaviour is relatively common in financial markets, but I would suggest that this tendency is magnified in the U.S. Treasury market. (Someone with a good quality database could run statistical tests on that assertion; it did seem to hold for the U.S. market versus other developed government bond markets.)

The usual explanation is that the reversal is driven by mortgage hedging demand. I was never an expert on U.S. mortgage-backed security markets, but the explanation seems entirely reasonable. To summarise, the hedging demand drives yields "too low," and then when rates reverse, the hedging goes the other way -- creating a V-shaped yield chart.

I suspect that this is a factor in the current yield drop. However, I need to add an immediate disclaimer: we do not know where the reversal will happen. For example, knowing that the 10-year yield will rapidly rise 50 basis points in the future does not help directional strategies if you do not know how far the yield will fall before that reversal. (Volatility trades could benefit.) As a result, the existence of hedging "distortions" is not enough to make money trading the direction of rates.

 

Quick Hedging Demand Primer 

The unusual structure of the U.S. mortgage market explains why the U.S. dollar market features these characteristic moves. Conventional mortgages fixed interest rate mortgages in the United States that are financed by the housing agencies offer homeowners the option to repay early. This means that if mortgage rates fall sufficiently, a homeowner can get a new mortgage that pays off the old mortgage, and either keep the same payment and get cash back, or lower the mortgage payment.

In a country like Canada, homeowners do not have the right to prepay the entire mortgage, and so this is not a factor in Canadian fixed income.

Although the ability to prepay mortgages is great for homeowners, it comes at the cost of the owners of the mortgages. There are two main classes of mortgage owners:

1. levered financial institutions (including banks) that borrow to finance "positions" in mortgages including non-securitised mortgages sitting on lenders' balance sheets);
2. bond portfolio managers that hold mortgage-backed securities against an index (or actuarial liability).

Since nobody likes seeing entities financing fixed coupon assets with floating rate debt, levered financial institutions typically issue fixed rate debt to finance those assets. This means that all the major holders that matter hold mortgages against some form of liability: debt issues, actuarial liabilities, or a bond benchmark that typically has a large component of non-callable bonds....

....MUCH MORE