Before looking at this mooted ‘duration trap’ and via way of a refresher, US Mortgage Backed Securities are described as being ‘negatively convex’ because in sharp contrast to conventional government bonds, MBS duration lengthens when interest rates rise, and shortens when rates fall. This is because when  mortgages) at the new lower rates, thus reducing the interest income on MBS, and by extension their value. Historically investors have ‘hedged’ expected changes in prepayments by buying or selling interest  movements and can lead to sudden spikes, as it did  the current situation and that 2003 episode is that the Fed, which owns some $1.75 Trln in MBS (ca 25% of the market) as part of its QE programme, does not ‘hedge’ pre-payment risks, which in turn has actually served to mute interest rate volatility. As the Fed gradually reduces the size of its balance sheet, so the need for private investors to hedge their MBS portfolios will rise, and per se exacerbate any sharper moves in US Treasury yields. The NY Fed estimates that it will no longer need to reinvest MBS proceeds by the middle of 2018, though much will of course on how rates evolve. For further insights please see:


http://libertystreeteconomics.newyorkfed. org/2018/01/balance-sheet-normalization-when- will-agency-mbs-holdings-decline.html


There will inevitably also be some concerns that the US government will now be running a much larger  but also as a consequence of the Fed’s balance sheet reduction programme (which will increase from $20 Bln per month in Q1 to a peak pace of $50 Bln in Q4 2018). But history shows that a large budget  markets, even in the era before there were large scale central bank purchases of government debt (be  trends (and expectations) tend to weigh far more heavily in the equation, as well as a country’s relative  have previously discussed, one of the most notable support for bonds has been demographics (see August 2017 Ghost In The Machine: “There’s more to low bond yields than central banks and 


5 | ADMISI - The Ghost In The Machine | January/February 2018


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