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For Powell, it's the Agony of the Convexity

“It is not learning, grace nor gear

Nor easy meat nor drink

But bitter pinch of pain and fear

That makes creation think”

They Told Barron: The Notes

of Clarence W. Barron (1930)

New York | Just how low is the lower bound in US mortgage rates? We may have found out over the past few months. The benchmark 10-year Treasury bond fell to almost zero this past couple weeks, but the companion 30-year mortgage has actually gone up in yield.

Now with the Fed dropping the target for fed funds to zero and restarting quantitative easing, will mortgage rates comply with the Fed's guidance? Our bet is maybe. But why are mortgage rates not falling? One word: convexity. When a mortgage bond goes down in price when everything else is rising, that is called convexity. To quote “Fabozzi Bond Markets and Strategies Sixth Edition,

“The key point is that measures (such as yield, duration, or convexity) reveal little about performance over some investment horizon because performance depends on the magnitude of the change in yields and how the yield curve shifts. Therefore, when a manager wants to position a portfolio based on expectations as to how the yield curve is expected to shift, it is essential to perform total return analysis.”

We are seeing one of those rare events, like a lunar eclipse, where unseen market forces actually thwart the intentions of central bankers and the hopes of a lot of mortgage lenders. We hear many complaints from the secondary mortgage channel about rising primary rates. Now the Federal Open Market Committee has overtly resumed quantitative easing and again includes mortgage backed securities on the shopping list. But will mortgage rates fall below 3%?