Always Winter, But Christmas is Coming: A Peak Into The Deeper Magic of Mortgage Volatility
"Why, it is [the White Witch] that has got all Narnia under her thumb. It's she that makes it always winter. Always winter, and never Christmas; think of that!"
- Mr. Tumnus
A few years ago, I described the seemingly perpetual, passive investing bull market in US stocks as the inverse of Narnian lore, where it’s always Christmas but never winter. Where prices always go up (even when earnings don’t!) and the bubble never bursts. While that has been a wonderful faux reality for many understandably naive US investors, that fantastical journey may be nearing its end, and we’ve discussed the reasons for that elsewhere.
However, in the vast, intricate wardrobe of our financial world, where every garment of debt and equity hangs in delicate balance, the bond market has found itself in a moment reminiscent of the Witch’s spell: it is always winter but never Christmas. For the first time in over 4 decades, the US Treasury bond market, the backbone of the global financial system, has been held in a state of icy tension as the price of long-term UST bonds have declined by 30-50% from their peak a few years ago. This financial winter is stifling investment, weakening the job market, and leaving much of main street out in the cold.
Yet, beneath this frozen surface lies a potent, often overlooked mechanism; something referred to as mortgage volatility. This contraption of such subtle power, once set in motion by the shifting seasons of interest rates, is poised to break the White Witch's spell, melting the ice and guiding long-term yields down to realms previously thought impossible. Like the melting of ice that signals the return of Aslan, the sheer mechanical necessity of this mortgage engine may soon usher in warmer weather.
The Financial Woods and the Sleeping Giant of Debt
Imagine, if you will, the American financial landscape as a sprawling forest. Within this forest lies a slumbering beast: mortgage debt. Today, this represents a staggering $13 Trillion of debt obligations, with a weighted average life (WAL) of about 9 years. This means that while most mortgages are 15-30 years in length, the average mortgage only lasts (before refinancing or selling) for around 9 years. This beast, though at times docile, holds within its very structure the potential for profound shifts, much like a slumbering lion whose roar can be felt for miles.
“Then [Aslan] isn’t safe?” said Lucy.
“Safe?” said Mr. Beaver. “Don’t you hear what Mrs. Beaver tells you? Who said anything about safe? ’Course he isn’t safe. But he’s good. He’s the King, I tell you.”
For many years, the guardians of this forest – pension funds, insurance companies, and hedge funds – have sought to tame this beast's inherent unpredictability. They do this through a subtle art known as duration hedging. Duration, for our purposes, is like the length of a tether holding a balloon. A longer tether means the balloon (or investment) bobs more dramatically with every gust of wind (interest rate change). The guardians wish to keep their portfolio balloons at a consistent, predictable height, regardless of the winds. The longer the average life gets, the more dramatic this beast can become when it is awakened.
The Peculiar Tether: MBS Duration and its Whims
Now, the peculiar thing about this duration beast is that its tether does not stay fixed. Instead, it is an adaptive, shrinking when the winds are favorable (falling interest rates) and lengthening when they are harsh (rising interest rates). When interest rates rose in 2022 and into 2023, the mortgage beast went silent and the WAL for mortgages rose from 4.5 years to 10. Much like the White Witch’s spell, this was an intentional effect of central bank policy, as Jerome Powell and his posse froze the housing market, pricing many people out of purchases while locking many others in their mortgages, thus ushering in a long, Christmas-less, winter. Today, the mortgage engine remains under the weight of interest policy induced winter with an average life still around 9. This is double what it was just a few years ago, which implies that, for now, the mortgage beast has been away far too long, delayed by the White Witch’s spell.
But herein lies the Deeper Magic, for the current environment is poised to unleash a cascade of events that will dramatically shorten this tether. Imagine a future where, over the next 12 to 24 months, the economic winds shift decisively as the financial markets realize that tariffs actually lead to lower prices (in a bad way, as they destroy demand), and the global economy is much weaker than anyone realizes. This reality is already emerging amidst the thawing ice, compelling central banks – lead by the white witch himself, Jerome Powell – to give up the inflationary bias inherent in their policy and admit the freezing of credit is quite harmful to middle America.
As the ice melts, US treasury rates will decline. Mortgage rates will follow. We have already seen mortgage rates fall from the mid 7% range to the low 6% range over the past year. But at some point, rates fall just enough to see emerald whispers of life emerging from the snow-covered branches of the evergreens. And then, a great stir will arise among homeowners! Thousands, then millions, will rush to unburden themselves of older, costlier mortgages, seeking new, cheaper ones. This is the refinancing wave, and it is the key to mortgage volatility. When old mortgages are paid off early, the average life of the entire $13 trillion beast's promises suddenly contracts, thawing the ice and beckoning the lion back from the deep forest to Narnia. Our tether, currently around 9 years, appears poised to shrink dramatically as interest rates move lower.
The Hedging Paradox: A Mechanical Thirst for Duration
Here's where the magic truly unfolds. The guardians of the forest, who have meticulously balanced their books (their portfolios) to maintain a steady tether length (duration), suddenly find their portfolios far shorter than intended. It's like having a hot air balloon suddenly lose half its helium; it sinks towards the ground. To bring it back to its desired height, they must quickly acquire more helium.
This "more helium" is duration, and in the financial world, the most reliable source of duration is the majestic U.S. Long-Term Treasury Notes, especially the 10-year variety. Thus, the mechanical response of these institutions is to rush into the market and BUY these long-term Treasuries. They don't buy out of speculation or a sudden love for government bonds; they buy out of necessity, to re-balance their interest rate risk. The White Witch is powerless to stop the melting ice and the return of the king of the beasts.
“Aslan a man!” said Mr. Beaver sternly. “Certainly not. I tell you he is the King of the wood and the son of the great Emperor-Beyond-the-Sea. Don’t you know who is the King of Beasts? Aslan is a lion—the Lion, the great Lion.”
Let us quantify this mechanical thirst, as we did in our earlier discussions:
- Lost Duration: A $13 Trillion mortgage market, losing 3-4 years of duration means a colossal amount of "interest rate sensitivity" has vanished. This represents a dollar duration change of approximately $40-50 trillion.
- Required Replacement: To replace this lost duration, these guardians must purchase 10-year Treasuries, or equivalent long-term treasury assets. Assuming a duration of 7 years for the 10-year Treasury, this equates to a staggering mechanical demand for roughly $5-6 Trillion in 10-year Treasury notes.
This is not a polite request for bonds; it is a mechanical, forced demand of epic proportions, driven by the very architecture of the financial system. At $5-6 trillion, the mechanical demand is multiples of the supply the treasury is expected to issue over the next few years, even with today’s historically high budget deficits.
The Shrinking Supply: A Tightening Bottle-Neck
But our tale has another twist, another layer of deeper magic. Not only will the demand for long-term Treasuries surge, but their supply may also become remarkably constrained.
For years, the U.S. government has been something of a prodigious manufacturer. No, not of goods. But of debt. Debt securities, to be exact. The US government loves to spend, and to subsidize this bad habit, it is constantly churning out fresh batches of debt to feed congress’s annual appetite to buy votes (ahem, I mean “govern”). But similar to the clownfish, who provide waste that nourishes the sea anemones, US government waste is the rest of the world’s food. Foreigners bought nearly $1 trillion of US debt last year, because they utilize the debt instruments in credit transactions and as savings tools outside of their own, reckless and dysfunctional financial systems.
Don’t shoot the messenger. I am not condoning this system, merely describing its dark underbelly!
And while recent years have seen annual budget deficits swell to over $2 Trillion in the US (providing lots of “food” for the rest of the world), this may not continue. This massive budget deficit is certainly the result of our government’s irresponsibility. However, driven by additional tariff revenue (not an endorsement!), lower interest rates, and perhaps better than expected economic growth due to less regulation and taxes, the deficit could well shrink from $2 Trillion annually to less than $1 Trillion annually over the next few years. It may even disappear entirely (don’t laugh, I said “may”).
Imagine the US government’s primary manufactured good (UST debt instruments) suddenly halving their production. The market, which has grown accustomed to a feast, now faces a much leaner offering. This means that at the very moment when the mechanical demand for treasuries is skyrocketing due to mortgage volatility, the fresh supply of these much-desired assets may be dwindling. It's like a great multitude suddenly realizing they all need water from a well, just as the wellspring begins to dry up.
The Inevitable Consequence: Yields to the Deeper Depths
So, we have a potent combination:
- Massive, Forced Demand: Over $5 Trillion of mechanical buying pressure for 10-year Treasuries.
- Shrinking Supply: A significant reduction in the amount of new 10-year Treasuries coming to market.
What is the inevitable consequence of such an imbalance? The price of those Treasuries will be bid up aggressively, and consequently, their yields will be driven down – dramatically.
Drawing upon empirical estimates (such as those from the Federal Reserve, which suggest a 4-9 basis point impact per $100 billion of sustained demand), we can gauge the impact of this on market interest rates and, thus, mortgage rates. If we use a conservative mid-range estimate of, say, 6 basis points per $100 billion of net demand, the total impact from the $5 Trillion in mechanical buying pressure would be equal to a 3.3% decline in US interest rates.
Starting from a current 10-year Treasury yield of 4.15%, a decline of 3.3% would place the yield at below 1%, at or below the lows last seen during the COVID lockdowns. Mortgage rates would likely not be much higher. This is, in my reading, a rather conservative estimate.
The mortgage volatility engine is not exogenous (i.e., it is not independent of the financial system), but rather feeds back into it. Lower interest rates speed up the shortening of mortgage duration, thus further increasing demand for treasuries, which in turn lowers their interest rate more. These relations are reciprocal. For better or worse, this means the ultimate lows in interest rates may be even more extreme.
Long term UST interest rates may go negative, as dumb as that sounds. And believe me, it is dumb. But it’s a consequence of a dumb system, so it makes sense. Sort of.
The Deeper Magic at Work
Just as the Deeper Magic of Narnia dictates that innocent blood shed for a traitor will cause the stone table to crack and death to work backwards, so too does the Deeper Magic of financial volatility dictate a powerful, often counter-intuitive outcome. The very nature of mortgage debt, when coupled with the need for hedging, creates an amplifying force that can drag down Treasury yields far lower than fundamental economic shifts alone might suggest. This can, in turn (and counter-intuitively) ignite growth in credit via the housing market as the estimated $35 trillion of US housing equity emerges from below the Fed-induced snow fall. The economy may return to positive growth for a time after this meltdown. Like the tech bubble, which melted down and facilitated the creation of the housing bubble in the early 2000’s, the late 2020’s may look eerily similar. Again, not an endorsement, just the system as it exists.
This is not to say that other forces – disinflation/inflation, global growth, geopolitical tensions, or the whim of other market participants – will be entirely absent. Like the White Witch and her goblins, the Federal Reserve is doing everything it can to prevent the mortgage volatility engine from kicking in to high gear and thawing the economy. Why would they do that, you ask? Because this engine will hurt the banks and likely deflate the tech stock bubble. It will also help main street, which would political ramifications in the 2026 mid-terms. But that’s a story for another time.
However, the mechanical force of mortgage volatility, combined with a potentially constrained supply of US government debt, represents a fundamental current that will tirelessly pull against these forces, guiding long-term Treasury yields towards a return of Christmas and eventually, much warmer weather. Middle America would welcome lower interest rates, as would the corporations that employ them.
The financial woods are full of wonders, both seen and unseen. But few are as potent and as demonstrably effective as mortgage volatility. And for those who understand its workings, the journey is less a mystery and more an inevitable unfolding of the Deeper Magic.
Postscript on Christmas
We may be tempted to put our hope in this analogous lion. A low-interest rate future would certainly be a welcome thing for many. However, low-interest rates without accompanying real savings by consumers will just lead to bigger asset bubbles and eventually, more dysfunction in the financial system. It’s a temporary reprieve. It is no salvation.
This life is full of false salvations; people and systems that make empty promises but inevitably fail. However, this time of year I want to encourage you, dear reader, regardless of your background or disposition, to celebrate something more than the analogous Aslan or the financial reprieve that may come from the mortgage volatility engine. Instead, celebrate something that will not disappoint. Celebrate the gift of the God-man Jesus Christ, and all the accompanying promises that He brings.
“For unto us a Child is born, Unto us a Son is given;and the government will be upon His shoulder.And His name will be calledWonderful, Counselor, Mighty God,Everlasting Father, Prince of Peace. Of the increase of His government and peace there will be no end,upon the throne of David and over His kingdom,to order it and establish it with judgment and justicefrom that time forward, even forever.” Isaiah 9:6-7