The recent spike in rates conjured up past fears of a massive sell-off, considering a sustained and rapid increase in interest rates would extend mortgage duration and slow prepayments. It's been a while since the markets contended with volatility in interest rates, and analysts are taking note.

Furthermore, the likely path of the unemployment rate could lead to a lift in zero interest rate policy, further increasing convexity risk — the sensitivity of a bond to changes in interest rates.

Federal Open Market Committee minutes show that certain macroeconomic benchmarks must be met before the Federal Reserve begins tapering its mortgage bond purchases or raises interest rates. As the economy continues to improve, we are getting closer to those benchmarks and analysts are now shifting from an 'if' position in their research, to a 'when' position.

"The reasoning is that if the trend' employment growth is just 80,000, then even historically moderate job gains of 200,000 per month would push down the unemployment rate by close to 1 percentage point a year," said analysts for Goldman Sachs (GS)

They added, "This implies that the Federal Open Market Committee would reach its current 6.5% unemployment threshold for the first hike in the federal funds rate by mid/late 2014; even if the committee explicitly or implicitly pushed down the threshold to 6%."

The prospect of a changing interest rate paradigm has also prompted analysts for the Royal Bank of Scotland (RBS) to rethink the potential impact of convexity hedging in such an environment.

Until recently, convexity hedging activity was muted for several notable reasons, specifically the Federal Reserve. But aside from the central bank, prepayments in recent years were driven by policy risk rather than interest rate risk, RBS explained. 

However, once rates begin to shift outside of exterior influence, as the Fed starts to taper its quantitative easing program, convexity and other interest functions should once again begin to play a critical role in the bond market.

A sharp increase in interest rates will also lengthen mortgage-backed securities as refinance activity slows down.

Once mortgage rates rise above 4.5%, half the mortgage market may not be refinancable based on rate incentive.

"If rates were to increase by another 25 basis points from their current level, we would expect the duration of the mortgage universe to extend by $186 billion in 10-year equivalents. This is much greater than the $154 billion extension in a 25 basis points backup estimated at the beginning of 2013," RBS analysts explained.

Consequently, there will also be an increasing demand in convexity hedging going forward.

For instance, although many MBS holders do not hedge out interest rate risk, a large percentage of MBS buyers do.

"Furthermore, given that MBS tends to be under-hedged in low rate and vol environments, it would not be surprising to see much stronger hedging activity as both levels rise," RBS analysts concluded. 

cmlynski@housingwire.com