Demand-supply imbalance risk and long-term swap spreads

We develop a model in which long-term swap spreads are determined by end users' demand for swaps, constrained dealers' supply of swaps, and the risk of future imbalances between demand and supply. Exploiting the sign restrictions implied by our model, we estimate these unobserved demand and supply factors using data on swap spreads and a proxy for dealers' swap arbitrage positions. We find that demand and supply play equally important roles in driving the observed variation in swap spreads. Yet, as predicted by the model, demand plays a more important role in shaping the expected returns on swap spread arbitrage, which embed a premium for bearing future demand-supply imbalance risk. Hedging activity from mortgage investors seems to play a key role in driving the demand for swaps. By contrast, the supply of swaps is closely linked to proxies for the tightness of dealers' constraints. Finally, our analysis helps explain the relationship between swap spreads and other no-arbitrage violations

Mortgage hedging in fixed income markets

We study the feedback from hedging mortgage portfolios on the level and volatility of interest rates. We incorporate the supply shocks resulting from hedging into an otherwise standard dynamic term structure model, and derive two sets of predictions which are strongly supported by the data: First, the duration of mortgage-backed securities (MBS) positively predicts excess bond returns, especially for longer maturities. Second, MBS convexity increases yield and swaption implied volatilities, and this effect has a hump-shaped term structure. Empirically, neither duration, nor convexity are spanned by yield factors. A calibrated version of our model replicates salient features of first and second moments of bond yields

Mortgage risk and the yield curve

We study feedback from the risk of outstanding mortgage-backed securities (MBS) on the level and volatility of interest rates. We incorporate supply shocks resulting from changes in MBS duration into a parsimonious equilibrium dynamic term structure model and derive three predictions that are strongly supported in the data: (1) MBS duration positively predicts nominal and real excess bond returns, especially for longer maturities; (2) the predictive power of MBS duration is transitory in nature; and (3) MBS convexity increases interest rate volatility, and this effect has a hump-shaped term structure

The macroeconomic effects of Government asset purchases: evidence from postwar US housing credit policy

We document the portfolio activity of federal housing agencies and provide evidence on its impact on mortgage markets and the economy. Through a narrative analysis, we identify historical policy changes leading to expansions or contractions in agency mortgage holdings. Based on those regulatory events that we classify as unrelated to short-run cyclical or credit market shocks, we find that an increase in mortgage purchases by the agencies boosts mortgage lending and lowers mortgage rates. Agency purchases influence prices in other asset markets and stimulate residential investment. Using information in GSE stock prices to construct an alternative instrument for agency purchasing activity yields very similar results as our benchmark narrative identification approach

Demand-and-Supply Imbalance Risk and Long-Term Swap Spreads

We develop and test a model in which swap spreads are determined by end users' demand for and constrained intermediaries' supply of long-term interest rate swaps. Swap spreads reflect compensation both for using scarce intermediary capital and for bearing convergence risk—i.e., the risk spreads will widen due to a future demand-and-supply imbalance. We show that a proxy for the intermediated quantity of swaps—dealers' net position in Treasuries—flipped sign during the Global Financial Crisis when swap spreads turned negative and that this variable predicts the excess returns on swap spread trades. Exploiting our model's sign restrictions, we identify shifts in demand and supply and find that both contribute significantly to the volatility of swap spreads