By Gertrude Chavez-Dreyfuss
NEW YORK, Aug 5 (Reuters) – Investors piled into U.S. swap futures early this week after a sharp back-up in Treasury yields, as investors scrambled to hedge against further increases in borrowing costs — a sign of concern that rates could stay elevated for longer.
The hedging activity appeared tied to mortgage investors seeking protection against the risk of higher rates extending the duration of their portfolios, traders said. In the mortgage sector, when Treasury yields rise, the duration in portfolios extends because homeowners are less likely to refinance, leading to lower prepayments.
To bring that duration back down to their target, investors typically pay fixed in interest rate swaps or swap futures — derivatives in which they exchange a fixed coupon with another trader for a floating rate. By paying a fixed rate in a swap, they add an investment that tends to gain value when rates rise, helping offset price declines on their mortgage holdings.
Investor hedging moves are closely watched because they can magnify swings in the bond market. When rising rates extend the expected life of mortgage portfolios, investors often shed interest rate exposure by selling Treasuries or adding hedges such as swap futures, which can push yields even higher, reinforcing the market move.
“There has been considerable discussion over the past month about mortgage extension risk as higher rates slow refinancing and prepayments, extend the expected life and duration of mortgage assets, and prompt investors to rebalance their associated rate hedges toward longer maturities,” said Michael Riddle, chief executive officer of Eris Futures, which develops futures products.
“While we don’t know the motivation behind anonymous block trades, the size and breadth of Monday’s activity in Eris SOFR swap futures across multiple maturities could be consistent with this dynamic,” he said, referring to mortgage hedging.
VOLUME LARGEST EVER BY ONE MEASURE
Eris swap futures tied to the Secured Overnight Financing Rate (SOFR) listed on the CME Group saw Monday’s volume surge to more than 167,000 contracts, equivalent to roughly $16 billion in notional value. That was more than six times the second-quarter average daily volume of $2.5 billion, Riddle said.
Monday’s volume was also the eighth highest daily total in the contract’s history and the largest ever on a “non-roll day,” he added, meaning trading was not driven by investors shifting positions from an expiring contract into a new one.
The volume also implied a “DV01” — an interest rate risk measure — of roughly $4.5 million per basis point, the Eris executive said. This means that the position’s value would rise or fall by that amount for each one basis-point move in interest rates. Traders said that equates to the interest rate risk of holding about $6 billion of 10-year Treasuries.
Hedging occurred after U.S. Treasury yields surged last week, with Federal Reserve Chair Kevin Warsh noting that financial conditions have already tightened significantly and markets have effectively done much of the work themselves in lifting both nominal and inflation-adjusted Treasury yields.
Tom Porcelli, Wells Fargo’s chief U.S. economist, said he believes “higher long-term rates are not going away anytime soon” — not because inflation is out of control, but because the U.S. economy has been surprisingly resilient amid strong corporate profit growth and overall optimism that the AI buildout will accelerate productivity.
HEDGING ACROSS THE CURVE
The hedging flows on Monday were concentrated in the two-, three-, five- and 10-year maturities, with a meaningful mix of front-month and older and less liquid off-the-run contracts.
Gennadiy Goldberg, head of U.S. rates strategy at TD Securities, said the move higher in rates created “significant paying needs” from investors to hedge mortgages.
“These flows make quite a bit of sense as investors often hedge via futures first and may also pay swaps as well.”
Over the past three years, non-bank mortgage originators have underwritten roughly $3 trillion of mortgages, many with coupons around 6–6.5%. As mortgage rates dropped toward those levels, prepayment risk was concentrated in the two- to three-year part of the curve, prompting hedging at the very front end.
But a recent backup of nearly 100 basis points in rates, with mortgage rates rising from about 6% to around 6.6%, has sharply reduced refinancing incentives. That shift effectively pushes cash flows and risk further out the curve, extending portfolio duration toward the five- to 10-year sector, Riddle said.
(Reporting by Gertrude Chavez-Dreyfuss, Editing by Colin Barr and Andrea Ricci )
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