Sliding U.S. yields may have further to fall, Goldman Sachs says

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A rally in Treasuries that's driven 10-year yields toward record lows could have more room to run.

The abrupt slide in rates, which came as the coronavirus outbreak spurred a flight to quality, may extend further as mortgage-bond investors adjust their duration risk, strategists at Goldman Sachs Group Inc. wrote in a Feb. 24 note. So-called convexity hedging helped fuel the decline in yields last year.

While convexity hedging hasn't yet been a significant factor in 2020's rate rally, the recent decoupling of duration and swap spreads for mortgage-backed securities could be short-lived. Investor responses to the shrinking duration of mortgage-backed debt have "likely amplified the more fundamental forces pushing the yield curve downward," Goldman's analysts wrote.

"Adverse data could still translate into a further 20bp decline in nominal yields, or even a 35bp decline if the data surprise is combined with a large negative hit to risk sentiment," the analysts wrote. A further decline in mortgage durations would also be likely in such a scenario.

An uptick in expected home-loan refinance rates has already reduced the duration of mortgage-bond indexes, removing about $1.6 trillion worth of 10-year Treasuries in interest-rate risk for MBS investors, Goldman calculates.

A bigger wave of hedging now stands ready to support a deeper Treasuries rally and traders are not taking any risks.

The sharp moves on Monday were matched with compressed dollar swap spreads, suggesting convexity hedging demands are starting to come into play. Long-end swap spreads dropped to the tightest levels since November 2019 during the New York session.

Meanwhile, investors spent millions of dollars on options to hedge the 10-year yield dropping as low as 1.10% by the end of the week. Other trades included a $11.7 million bet on yields falling to 1.25% by late March.

Bloomberg News