In a recent note, Goldman Sachs estimated that a $200 billion build in mortgage holdings could boost the holdings of active mortgage convexity hedgers by around 25%. This increase in hedging activity has the potential to significantly impact market participants, particularly in times of volatility.

To understand the implications of this estimate, it’s important to first define what mortgage convexity hedging is. Mortgage convexity refers to the curvature of the yield curve for mortgage-backed securities (MBS). When the yield curve is concave, the value of MBS increases as interest rates fall. However, when the yield curve is convex, the value of MBS decreases as interest rates rise. This creates a challenge for investors who hold MBS, as they must navigate the changing interest rate environment.

Goldman’s estimate suggests that a significant increase in mortgage holdings could lead to increased hedging activity among market participants. Hedging involves taking positions in financial instruments that offset the risks associated with holding MBS. By hedging against convexity risk, investors can reduce their exposure to changes in interest rates and protect their investments.

The potential impact of Goldman’s estimate on market participants is significant. In a 50 basis point rally or sell-off in 10-year equivalent yields, the paying/receiving flow could increase by around $20 billion, assuming the accumulated mortgages are current production. This amplifies larger moves in the market and can have a substantial impact on investors who hold MBS.

It’s important to note that the initiation of hedges can also bring some widening to swap spreads, particularly in the belly of the curve. However, the exact implications of this will depend on the instruments used (i.e., swaps and swaptions versus Treasury futures). Heavier use of futures undercuts the initial impact on spreads and/or the extent of spread/rate directionality as rates move.