The Convexity Conundrum: Deconstructing the Asymmetric Transmission of Monetary Policy to Mortgage Rates

The transmission of monetary policy to the real economy is a cornerstone of modern macroeconomics, with the housing sector serving as a principal conduit. Conventional wisdom posits a straightforward, almost mechanical, linkage: the central bank adjusts its policy rate, which ripples through the yield curve, ultimately influencing the mortgage rates offered to consumers. However, empirical observation reveals a more complex and often frustrating reality. The transmission mechanism is frequently characterized by significant frictions, lags, and a pronounced asymmetry, particularly a downward stickiness in mortgage rates even as benchmark sovereign yields decline.

This phenomenon is not a market anomaly but the logical outcome of the intricate financial engineering that underpins the modern housing finance system. A deep analysis of the U.S. mortgage market reveals that the transmission from policy rates to the borrower's coupon is mediated by the structure of Mortgage-Backed Securities (MBS). The critical feature of these instruments is an embedded prepayment option held by the borrower, which induces negative convexity in the asset's price-yield profile. This article deconstructs this mechanism, arguing that the market's pricing of this prepayment risk, via the Option-Adjusted Spread (OAS), combined with shifting macroeconomic regimes that influence the Term Premium (TP), provides a robust framework for understanding the asymmetric and often weak pass-through of monetary easing to homeowners.

The Standard Model of Transmission and Its Empirical Failings

The canonical model of monetary policy transmission to mortgage rates follows a clear causal chain. The Federal Reserve sets the Federal Funds Rate, which anchors the short end of the risk-free curve. Through expectations and arbitrage, this policy stance influences longer-term Treasury yields, with the 10-year Treasury note (Y10Y​) serving as the primary benchmark for fixed-income assets. Since mortgages are long-duration assets, the 30-year fixed mortgage rate, as measured by indices like the Freddie Mac Primary Mortgage Market Survey (PMMS), is theoretically priced as a spread over this benchmark yield.

A cursory look at historical data confirms a general co-movement. However, it also highlights significant and prolonged periods of divergence. The 2013 "Taper Tantrum" saw Treasury yields and mortgage rates spike independently of the Fed Funds Rate. More recently, during the 2022 inflation shock, mortgage rates surged far more aggressively than their underlying benchmarks. Most critically, in the current environment, efforts by the central bank to rein in inflation and signal future easing have not translated into commensurate relief for homebuyers; the spread between the 30-year mortgage rate and the 10-year Treasury yield has remained stubbornly wide. These empirical puzzles challenge the simplistic model and necessitate a deeper dive into the plumbing of the mortgage market.

The Core of the Friction: Negative Convexity and the Borrower's Prepayment Option

The disconnect arises because a mortgage is not a simple loan; it is a complex bundle of rights. The majority of U.S. residential mortgages are securitized into MBS, which are then sold to capital market investors. The defining feature of these securities is that the homeowner retains the right to prepay the mortgage at any time without penalty. This right is economically equivalent to the MBS investor having written a call option to the homeowner on the underlying debt. When interest rates fall, the homeowner can exercise this option by refinancing into a new, cheaper mortgage.

This embedded option fundamentally alters the risk profile of the asset, introducing what is known as negative convexity.

Understanding Convexity

For a standard ("option-free") bond, the relationship between its price and yield is inverse and convex. Convexity measures the rate of change of the bond's duration as interest rates change. Mathematically, it is the second derivative of the price-yield function, scaled by price:

C=P1​dy2d2P​

Positive convexity is a desirable trait for investors. It means that as yields fall, the bond's price increases at an accelerating rate. Conversely, as yields rise, the bond's price falls at a decelerating rate.

The Impact of the Prepayment Option

The prepayment option turns this relationship on its head.

• When rates are high: The option to refinance is "out-of-the-money." Prepayments are low, driven primarily by non-economic factors like moving or default. In this state, the MBS behaves much like a standard bond, exhibiting positive convexity.

• When rates fall: The refinancing option becomes "in-the-money." Homeowners are incentivized to prepay their high-coupon mortgages. For the MBS investor, this is a worst-case scenario: their high-yielding asset is returned to them precisely when reinvestment opportunities are poor. This prepayment shortens the expected duration of the MBS, causing its price appreciation to slow, halt, or even reverse. This is negative convexity.

This structural feature is the primary source of the asymmetric policy transmission. When rates are rising, the transmission to mortgage rates is relatively efficient. But when rates are falling, the prepayment risk becomes acute, and investors demand compensation for the possibility that their cash flows will be truncated.

Pricing the Risk: The Option-Adjusted Spread (OAS)

Capital markets have developed a sophisticated tool to price this state-contingent prepayment risk: the Option-Adjusted Spread (OAS). The OAS is the excess yield an MBS offers over the benchmark Treasury curve after the cost of the embedded call option has been stripped out. It represents the pure compensation an investor receives for bearing the uncertainty of cash flows.

The final mortgage rate offered to a borrower can thus be deconstructed into several key components:

PMMS30Y​≈Y10Y​+TP+OAS+Gfee​

Where:

• PMMS30Y​ is the 30-year primary mortgage rate.

• Y10Y​ is the benchmark 10-year Treasury yield.

• TP is the Term Premium, the compensation investors require for holding long-duration assets against the risk of unexpected inflation or interest rate changes.

• OAS is the Option-Adjusted Spread, the compensation for prepayment risk.

• Gfee​ represents guaranty fees (charged by Fannie Mae and Freddie Mac for default insurance) and other loan servicing costs.

The stickiness of mortgage rates can now be understood through the behavior of the TP and OAScomponents. Even if the Fed's actions successfully lower the benchmark yield (Y10Y​), if market conditions cause TP or OAS to widen simultaneously, the effect on the final PMMS rate will be muted or entirely offset.

Macroeconomic Regimes and the Dynamics of Transmission

The behavior of the Term Premium and OAS is not static; it is highly dependent on the prevailing macroeconomic environment. We can analyze two distinct regimes that illustrate this dynamic.

Regime 1: Low Volatility and Policy Accommodation (e.g., the 2016-2019 Period)

This regime is characterized by low and stable inflation, predictable monetary policy (e.g., gradual rate adjustments), and manageable government debt issuance. During such periods, the mortgage transmission mechanism functions efficiently.

• OAS is low and stable: With low interest rate volatility, the value of the prepayment option is diminished. Investors can model prepayment speeds with greater confidence, and the risk premium they demand (OAS) is compressed.

• TP is contained: In an environment of quantitative easing or simply stable fiscal financing needs, the market for long-duration assets is not saturated. Investment banks can easily underwrite and distribute new Treasury and MBS issuance, keeping the term premium in check.

In this "sleeping cat" state, the TP and OAS components are well-behaved. The primary driver of the mortgage rate is the benchmark Treasury yield. As a result, monetary policy transmits smoothly—when the Fed hikes, mortgage rates follow in a predictable manner.

Regime 2: High Volatility and Fiscal Dominance (e.g., the Current Environment)

This regime is defined by heightened uncertainty, volatile interest rates, and significant fiscal deficits that necessitate massive issuance of long-duration Treasury debt. This environment causes a fundamental breakdown in the transmission mechanism.

• OAS widens dramatically: The prospect of future Fed rate cuts and high rate volatility makes the prepayment option extremely valuable. Homeowners are poised to refinance at the first opportunity. Investors, facing the high probability of their MBS holdings being called away, demand a significantly higher OAS as compensation for this acute reinvestment risk.

• TP widens: Large fiscal deficits force the Treasury to flood the market with long-duration bonds. When this supply outstrips the natural absorption capacity of the market (e.g., from pension funds and foreign buyers), dealers are forced to absorb the excess inventory. To be induced to hold this additional duration risk, they demand a higher term premium.

In this environment, even if the Fed signals or executes rate cuts, leading to a fall in Y10Y​, the concurrent explosion in both OAS (due to prepayment risk) and TP (due to supply indigestion) creates a powerful counterforce. The sum of these widening spreads offsets the decline in the base rate, leaving the final mortgage rate (PMMS) stubbornly high. This explains the current "stickiness" and the frustration of policymakers seeking to provide relief to the housing sector.

Synthesis and Policy Implications

The asymmetric transmission of monetary policy to mortgage rates is not an aberration but an intrinsic feature of a market built on securitized, pre-payable debt. The negative convexity of MBS acts as a "convexity tax" on monetary easing, a tax that becomes exorbitantly high during periods of market volatility and fiscal expansion.

This has profound implications for policymakers. The Federal Reserve's ability to influence the real economy via the housing channel is state-contingent. Its efficacy is significantly blunted when fiscal policy runs large deficits, as the resulting supply of government debt directly competes with MBS for scarce investor capital, driving up the term premium. Simultaneously, the very act of signaling future easing in a volatile environment can paradoxically keep mortgage rates high by inflating the value of the prepayment option and widening the OAS.

In essence, monetary policy does not operate in a vacuum. Its transmission is filtered through the complex, rational pricing of risk in the capital markets. The stickiness of mortgage rates is a clear signal that investors are demanding to be compensated for the dual risks emanating from both the monetary (rate volatility) and fiscal (duration supply) authorities.

The elegant machinery of monetary policy, therefore, meets a rugged and unforgiving reality in the MBS market. Until the macroeconomic regime shifts toward lower volatility and a more sustainable fiscal-monetary policy mix, the convexity conundrum will persist, complicating the economic landscape for central bankers, investors, and homeowners alike.