As far as bond buyers go, the Federal Reserve is prettylaid-back.

Even as the central bank amassed trillions of dollars of debt toprop up the economy following the financial crisis, it didn't hedgeits holdings or worry about gains and losses that might keepordinary investors up at night. This extreme buy-and-hold stancehas had an incredible calming effect on the bond market. Volatilityhas plummeted to lows rarely seen in recent memory.

But all that is now poised to change. With interest rates on therise, analysts say the Fed could start shrinking its unprecedented$1.75 trillion position in mortgage-backed securities by year-end.That's likely to leave more in the hands in private investors andresult in increased hedging activity, a practice that hashistorically exacerbated swings in the Treasury market.

“You'll inevitably see more volatility,” said David Ader, thechief macro strategist at Informa Financial Intelligence.

In 2003, a surge in “convexity hedging” triggered widespreadlosses in Treasuries as benchmark yields soared 1.45 percentagepoints in two months. Nobody is predicting anything close to arepeat. After all, the biggest hedgers back then weregovernment-sponsored entities like Fannie Mae and Freddie Mac,which now own just a fraction of what they did and aren'tcoming back.

But at a time when beleaguered bond investors are grappling withhigher rates and the potential consequences of the Trumpadministration's spending plans, the prospect of more volatilityadds yet another thing to their list of worries.

What exactly is convexity? At its most basic, it's a measure ofa bond's relative sensitivity to changes in interest rates. When abond has positive convexity, that means its price rises more thanit falls when yields move. When it's negative, like mortgage debt,its price falls more. When rates rise, hedging againstconvexity grows as the expected life of mortgage debt increases.That happens when refinancing slows, and tends to leave holdersmore vulnerable to losses.

But by protecting against those potential losses (sellingTreasuries or entering into swaps contracts are two ways), traderscan end up making the bond market more turbulent. That's alreadystarting to happen.

On March 9, analysts say hedging activity was triggered when10-year yields hit 2.55% and then 2.6%, which in turn, pushedyields to a three-month high of 2.628% March 14. They slipped to2.50% at 8:30 a.m. New York time Monday.

Tighter monetary policy may accelerate hedging. The Fed lift itsbenchmark rate a quarter-percentage point last week and signaledtwo more hikes this year. A few firms like RBC Capital Marketssay Fed officials will start paring back their MBS re-investmentsas soon as the fourth quarter. (Most predict the first or secondquarter of 2018.)

New Urgency

“This is a story that will play out over the course of a coupleyears,” said Jason Callan, head of structured products at ColumbiaThreadneedle Investments, which oversees about $500 billion. “Thiswon't be a big bang type effect, yet there is certainly reticencein the marketplace as to when the Fed's reinvestment announcementwill happen and what it will look like.”

Minneapolis Fed President Neel Kashkari, the only official tovote against this month's rate hike, added new urgency to thediscussion when he said last week that he would prefer the centralbank announce a plan that explains how and when it will begin toreduce its balance sheet before boosting rates again.

It's not just hedging in the MBS market that could hitTreasuries. Insurers, which have been buying protection againstlower yields for years, may now do the opposite, especially if theupswing in growth and inflation continues and share prices keeprising, said Dominic Konstam, Deutsche Bank AG's global headof rates research.

“That switch can flip if there's a real breakout of the secularstagnation story,” he said.

More volatility could make it harder for investors, but anypick-up in trading would be a big win for Wall Street.

Big banks, facing a profit squeeze in recent years, curtailedtrading in mortgage-backed securities, and in some cases,completely exited the business. Trading desks may also see a boostas investors unwind positions they were forced into when the Fedbought up the all MBS, according to Mark Tecotzky, co-chiefinvestment officer of Ellington Residential.

“It will result in better profitability for banks,” said BradScott, head of trading at RBC Capital Markets in New York. WallStreet “will have more opportunities based on higher volatility,and there will be more participants that are likely to enter themarket.”

Bloomberg News

Copyright 2018 Bloomberg. All rightsreserved. This material may not be published, broadcast, rewritten,or redistributed.