Value Commentary

Be Wary of the Slope
by Alex Levin

Real economy versus arbitrage-free economy
For mortgage investors and risk managers, the slope of the interest rate term structure should not be viewed as a forecasting indicator. In the real economy, the curve is steep most of the time. For the last 10 years, the 10-to-2 spread has been +1% on average and never negative (not even a day!); yet the 2-yr rate today is 2% below its value in 1993. The reason for the steep curve is not, of course, the rate expectation (market can't believe rates will always surge), but positive compensation for the risk of holding longer-duration bonds. Other factors contributing to the shape of the curve - expectation and liquidity (demand-supply imbalance) - may vary in time by sign and magnitude.

In the "arbitrage-free economy", which is a purely mathematical pricing construct, these three factors are collapsed into one - the value-equivalent rate expectation. Some practitioners, unaware of the meaning of this approach, literally think that the curve reflects "market consensus", "rate anticipation", etc. Analysts even receive tasks from their senior managers and executives: stress test and report the income or value assuming rates will grow as "pointed by" the market. However, an abnormally steep slope, such as the one observed now, or yield curve inversion may indicate an actual expectation bias toward higher or lower rates in the future - in the absence of an anomaly in risk perception or market segmentation.

Curve as the source of market risk
Instead of "reading the market's mind", FAS 133 forces managers of certain investment assets to periodically assess interest rate risk and comprehensively hedge against it. This includes hedging activity against the curve's dynamics - flattening, steepening, or inversion.

Today, the modeled forward 30 year FNMA current coupon index (MTGEFNCL) rises from its current value (5.67%) by 50 bps in just 10 months, by 100 bps in 24 months and by 150 bps in 48 months. Let us think of the valuation consequences if the curve completely flattens assuming no change in immediate mortgage rates. The forward mortgage rates will become flat as well, i.e. much lower than they are today, and will accelerate prepay speeds as seen in Figure 1 on the next page. >>>