Monday December 12

Stocks were mixed to start the week, with investors anticipating the Fed’s meeting this Wednesday. The S&P 500 fell 0.1% to 2,256 while the Dow Jones rose 0.2% to 19,796. Utilities rose 1% while the KBW Bank index lost 1.3%. Energy shares rose by the largest amount after non-Opec producers agreed to cut production along with the organization. While the market for Fed funds futures is pricing in a 25bp hike this Wednesday, investors will pay closer attention to the Fed’s forward guidance as well as the updated dot plot. On that backdrop the two year yield was unchanged at 1.14%. Additionally the 10 year yield finished 1bp higher at 2.48% after earlier touching a 17 month high at 2.52%. 2yr vs 10yr bear steepened to 1.34%. Germany’s 10 year yield rose 3bp to 0.40% as the ECB appears willing to implement a steeper yield curve. The dollar weakened today against peers. USD fell 0.7% against EUR to $1.0639. USD fell 0.3% against JPY to Y115.07. USD fell 0.8% against GBP to $1.2678. In commodity markets oil prices rose after the non-Opec producers agreed to cut productions along with Opec. WTI rose 2% to $52.51 and Brent rose 2.1% to $55.49.


Given the significant increase in interest rate some analysts are considering the effects of interest rate hedging of agency MBS. Investors who buy MBS typically sell interest rates as a hedge. Yields have shot up from around 1.80% pre election to 2.46% at close on Friday. Given the dynamics of interest rate hedging and the technical drivers of that market yields may increase even further. Investors in agency MBS are exposed to negative convexity which increases their exposure to interest rate swings in either direction. Analysts expect that given the convexity trade (the degree to which investors sell Treasuries amid rising interest rates), the convexity flow could lead the Treasury rate to increase even further if certain technical levels are hit. For example according to TD securities if the 10 year yield increased to 2.75% the market could “very well overshoot to 3% due to the convexity flow.” It is expected that refinancings in the market will decrease significantly considering that the current mortgage rate is around 4.15% and less MBS are now in the money for borrowers to refinance on. However some analysts believe that given certain changes that have taken place in the market the effect on Treasuries will be less pronounced. Ten years ago Fannie and Freddie owned 22% of outstanding agency MBS. Considering that those two institutions actively manage and hedge their portfolios, the convexity trade had a larger effect on markets. However their holdings have shrunk to around 8% of the market as a result of government, and at the same time the Fed’s holdings have increased from nothing to 17% of the market. The Fed leaves its portfolio unhedged and therefore the convexity trade will be less impactful on the market as a whole. However Bank of America’s MOVE index indicates that more investors have made bets on higher interest rate volatility, which is one way MBS investors can hedge against negative convexity. Typically selloffs in Treasuries lead to a widening in swap spreads, however this time around swap spreads have remained constant. That is because wider budget deficits (which are expected to occur in light of Trump’s election) normally coincide with tighter spreads.

Exchange traded notes were once popular among investors, however even though many have been delisted they still trade in markets. In 2011 nearly 80 ETNs were launched and barely any were delisted or liquidated. As these have fallen out of favor over the last few years, less than 20 have been launched while 30 have been delisted. The 61 ETNs that have been delisted leave investors with $4bn in assets that are now vulnerable to large fluctuations. Delisted products make it difficult or impossible to create new shares, which is necessary to keep the product’s price in line with the underlying assets. Products that were delisted from major exchanges now only trade in markets with less price transparency. ETNs are similar to ETFs, however ETFs own the underlying assets while ETNs do not. ETNs are a debt product and if the bank or company that issued the product goes bankrupt the ETN loses its value. Given regulatory constraints banks have turned away from this business. ETNs do not expire until they mature, so delisted ETNs can exist in the market for extended periods of time. Similar to ETFs, ETNs can trade at a premium or discount. These premiums/ discounts are significantly larger for delisted products since banks no longer support share creation. These are a high cost product for banks to offer, which is why banks such as Credit Suisse have been exiting the business.

The rally in stocks last week may have in part been driven by activity in the E-Mini futures market. On Wednesday someone bought 16,000 E-mini S&P 500 futures which amounts to a $1.8bn trade and the largest of its kind all year. The previous largest transaction of the year was a 7,000 contract sell order. While the S&P 500’s gains had been muted up until that point on Wednesday, they soon rallied to a new record. Analysts believe that a computer algorithm executed the order when the S&P 500 hit a trigger level, seemingly 2,225 according to the data. While volumes typically spike around the market close, the size of the intraday transaction on Wednesday was definitely an anomaly.

Monday December 12

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