Taking a “short position” in either Japanese interest rates or their currency is a fundamentally sound idea; however it may take three to seven years for the “Macro-profits” to be fully realized. Over that time, a short position will demand a cost, either in the terms of the negative carry of a spot position or the time decay of a short-dated option. Additionally, since it is unlikely you will enter the trade at the extreme, there could be some mark-to-market vibrations that may breach your risk limits. To the rescue is the strange circumstance of a widening USD vs. JPY Rate differential in conjunction with a flattening Volatility Term Surface. Below is a table of mid-market values for Par Strike USD call // JPY put options with expiries from one-year to ten-years. The critical observation is that a five-year option costs more than a ten-year option; thus the weird dynamic of owning an option with (effectively) positive “theta”: You are paid to own an option !
It is not a good time for Janet Yellen. The one time Bernanke-replacement favorite who many were confident would be the next Fed chair, and whose odds in the initial stages of the Fed race were 75%, is so far out of the running one can almost ignore her candidacy. At least if the market makers behind Paddy Power, and the Fed Chair market betting participants have it right. As of today, her odds have slumped to the lowest in the life of the contract, or 29.4%, below the 36.4% from mid August. The leader by an even greater margin: Larry Summers whose 2/5 odds, or 70%, mean that absent a material change in rhetoric, will be the person Obama announces as Fed chairman replacement over the next month.
With all eyes fixed on GDP and unemployment data this week (and all their revised and propagandized unreality) for more hints at if (not when) the Fed will Taper; the dismal reality that few seem willing to admit is that it is when (not if) and that the announcement of a "Taper" has nothing to do with the economy. There are three key factors driving this decision: Bernanke's bubble-blowing and bond-market-breaking legacy, the political 'clean slate' his successor needs, and, most importantly, the fear that QE will be discovered for what it is - monetization. As BoJ's Kuroda admitted last night "if QE is seen as financing debt, this could lead to rise in yields." With deficits falling, the Fed's real actions will be exposed (unless QE is tapered) and as Kyle Bass has explained before, it was out of the hands of the BOJ (or The Fed) and entirely up to market psychology.
It seems everyone and their pet Goldfish has been brainwashed into the belief that because it's an election year, we have to buy stocks. There is plenty of noise in that empirical study with some large outliers. However, Credit Suisse's Harley Bassman notes there is another cycle in election years - that of implied volatility - and he adds "the clearly defined economic nature of this election should increase implied volatility on most financial assets." As the chart below shows, volatilities tend to trough in August and peak in October into a November election - only to fall once again from two-weeks before to one week after the election. The pattern is clear.
Something quite disturbing happened during today's latest attempt by the Fed to sell $3.8 billion in face amount of Maiden Lane 2 assets: it had a busted dutch auction. In fact, the auction was so massively busted, the New York Fed managed to sell only half of the bonds for sale, or $1.898 billion in 36 Cusips of the total 73 Cusips offered for sale. Suddenly, the Fed's attempts to sale piecemeal portions of the $31 billion Maiden Lane II portfolio that was offered to be repurchased by AIG, and subsequently was offered for open auction as Zero Hedge first suggested, is starting to backfire, after a month ago several traders complained that instead of "dribbling" out small piece of the portfolio (the previous average auction block notional for sale was under $1 billion). As per Housing Wire from May 17, which cited a complaint by an MBS trader: "if you charge ahead and bleed out one or two lists a week for the next
10 to 12 weeks, prices will continue to go lower, and in the interest of
maximizing value for the taxpayer, I think it is time to re-engage the
large portfolio bid you had or make available to other counterparties
the ability to bid large chunks of what you have left to sell." Well, the trader got what he wanted... And in the process may have blown up the credit market. As Bloomberg reports, "Federal Reserve auctions of mortgage securities that the central bank assumed in the rescue of American International Group Inc. are fueling a selloff in credit markets as Wall Street rushes to hedge against losses on stockpiled debt." Sure enough, someone focusing on the equity market may be completely oblivious to the devastation that has been unleashed on HY and IG traders: "Declines in credit-default swaps indexes used to protect against losses on subprime housing debt and commercial mortgages accelerated this month, reaching almost 20 percent in the past five weeks as the cost of the insurance climbs, according to Markit Group Ltd. The plunge this week started infecting everything from junk bonds to the debt of financial companies." And while as Bloomberg points out that there is a confluence of technical and fundamental factors affecting credit sentiment, "You almost have a perfect storm of events,” said Shah of AllianceBernstein. “You have both the fundamental justifications for the market going lower and you have the technicals being created by Maiden Lane” there is a far scarier implication. If dealers and funds are unable to handle a mere $31 billion MBS portfolio disposition, and its weekly sale (think of its as a reverse repo) is starting to cause massive ripples in the bond market, just what will happen when dealers are forced to hold back the tens of billions in weekly bond auctions they freely flip back to the Fed now. In other words, is the credit market on the verge of a oversaturation implosion (hence the title)?
Must read observations from Merrill's Harley Bassman, formerly head of the RateLab: "Maybe I am showing my age, but I can assure you that as World Political events go, what is happening in the Middle East is actually the BIG ONE...The reason there is no "Flight to Quality" bid for USTreasuries is that USTs are no longer the "Quality" asset. Since the FED has turned on the printing presses, the "value" of the dollar has steadily declined. This is why the "Flight to Quality" is happening in Gold, Oil, Copper, Cotton, etc...Attention all you non-inflationists (and you know who you are), what more evidence do you need that the Govt's Plan "A" (inflation) is well underway?"
Harley Bassman's Model Portfolio For 2011, And Why "It Is Just A Matter Of Time" Before The Fed Creates InflationSubmitted by Tyler Durden on 01/05/2011 20:08 -0500
Harley Bassman, who used to head Merrill's RateLab, and who was one of the most erudite sellside voices on rate matters, and doubly so on mortgage issues, and subsequently moved to Merrill's prop side, has kept a low profile recently. Which is why we are happy to present his model portfolio for 2011. Bassman is a firm believer in inflation (synthetic or real), and we for one would pay good money to see the redux of the Rosenberg vs Grant debate in 2011 be Rosenberg vs Bassman. Bassman's conclusion, even though obtained in a circuitous way to our own, is comparable to the Zero Hedge thesis that the Fed will have no choice but to eventually create inflation. "In a nutshell, the FED (with the help of the Govt), is going to
engineer some type of Inflation to reduce the value of both our Private
and Public Debt. Since Inflation is the only solution, it will happen;
it is just a matter of time. Since the entire G-7 is in the same boat,
trading in Euro or Yen is purely a short-term speculation since all
these currencies will be heading south." Where Zero Hedge and Bassman, however, differ, is that we are certain that the Fed will be unable to contain said inflation once it has finally been unleashed, resulting in a complete wipeout of all assets that are directly or indirectly a rate derivative (ref: a very notable reparation paying, post-WW1 central European state), which means all fiat derivatives, leaving only hard assets in the wake.
Exclusive: 4 Dealers Respond With "$1+ Trillion" To Fed Reverse Inquiry Into How Much QE2 Is NecessarySubmitted by Tyler Durden on 10/28/2010 13:38 -0500
Yesterday we made a big stink over the Fed's reverse inquiry into the PD community over how much QE2 it should launch. Today, we find out what the distribution is: as Merrill's Harley Bassman points out: "Four dealers are predicting a $1+ Trillion buy program." It is good to finally know what the bogey is.
Harley Bassman, who used to run Merrill's successful RateLab and is now a prop trader, has sent the following note to clients. Note the bolded text: "The market has become dispeptic about the Payroll event. It is unclear if the FOMC is the BIG event (irrelevant of the data) or do the core inputs matter more. In a nutshell, will tomorrow's data shed any light on the next FOMC ? Last week the options market did now know what to think about QE2. That has all changed....or at least a few large customers have changed our collective minds. Massive option selling has reduced the cost of risk by over 12% in in two days. At least a few customers "know the number" of the FED." Our question: when, if ever, will the market become a level playing field, where everyone acts on the same information? How long will such wholesale approved and encouraged insider trading be permitted for the select few? And, lastly, when will the world rid itself of the Fed once and for all?
Earlier today we noted that the biggest buzz on Wall Street is the recent suggestion by MS and ML's Harley Bassman that the GSEs should provide some form of autorefi program to take borrowers to market rates. As this would impact a vast majority of the 37 million of mortgages outstanding backed by the government, not only would this housing stimulus have a huge impact on consumption appetites, but it would be a political coup as all of a sudden the administration would find tens of millions of giddy homeowners who are paying far less monthly, and quite satisfied with the way Obama has handled things. It is thus likely that this program will take off shortly (if at all) just before the mid-term elections to neutralize all the pent up discontent focused on the administration. Yet there may be less than meets the eye. As Market News points out, over the past 24 hours Wall Street has gone into overdrive analzying the consequences, both positive and negative, of such a move. Below are the conclusions.
So far the stock market has has been having its cake, and eating it with relish too. With stocks having rallied almost 80% from the lows, the one market participant that still seems to not have gotten the memo of a surging economy is the bond market. To the credit of Merrill's Harley Bassman, 10 Year spreads have been trading in a tight range between 3.2% and 3.8% for almost a year (no doubt in big part precipitated by the Fed's control of a vast portion of the bond and MBS market). Should equities take another major leg higher, whether due to NFP or other reasons (most likely momentum inertia), it is very likely that the 10 Year, which many believe has been patiently waiting for deflation to finally be realized, will finally snap its tight trading range and go higher. Much higher. Morgan Stanley sees the 10 Year going wider by 60 bps in the next 90 days.
The Latest Spin In The GSE "Take From The Poor And Give To The Rich" Saga: The Reverse Robin Hood ConstructSubmitted by Tyler Durden on 02/12/2010 13:36 -0500
"Let’s place pencil to paper. Public documents point to about $221 billion of UPB loans that are 90+ days delinquent. Assuming an average 6% net coupon, the two GSEs are ultimately forwarding $1.11 billion each month to the holders of Passthrough bonds whose underlying loans are delinquent. If the GSEs were to buy out all of these loans, they could in theory fund it somewhere near 20bps running or roughly $3.7mm a month. As such, by not buying out these loans, the GSEs are overspending by about $12.8 billion annually.
Since the GSEs are under conservatorship with a large credit backstop from the US Treasury, they are for all intents and purposes owned by the taxpayers. And since the average taxpayer is by definition average, he is therefore not “rich” since “rich” tends to be defined as possessing well above average wealth. Furthermore, the mere fact that bondholders have funds to invest in such bonds disqualifies them from being categorized as “poor”. Although not all bondholders are “rich”, those who have such substantial excess funds that they can invest in bonds are probably closer to rich than average. Taken altogether, one could consider the fact that the GSEs are using taxpayer funds to advance a 6% coupon to bondholders when they could be funding this cost in the public markets at 20bps to be in essence a “Reverse Robin Hood” situation." - Harley Bassman, Merrill Lynch
Open Letter To The Treasury: Use The Short Squeeze In The FN/FH 5s/5.5s Bonds To Support An “Auto-ReFinance” ProgramSubmitted by Tyler Durden on 02/02/2010 18:09 -0500
"On August 27, 2008 we published “An Open Letter to the Department of Treasury” where we advised the Government to buy $500bn FN 5.5s (then trading at 98-16) and fund it by issuing $500bn Treasury Five year notes (then priced at 3.02%). [Note: CMM vs. 10CMS was at 135bps]
Soon afterwards, they took our advice in spades, eventually agreeing to buy $1.25Trillion MBS bonds. This has lowered the Par MBS rate by over 140bps and tightened spreads by 70bps. (Actually, 165bp and 125bps respectively from the Post-Lehman wides.)
Unfortunately, this policy brilliance has not been executed in the most optimal manner. This has resulted in a missed opportunity to reach deep into the market to help those homeowners who are most distressed." - Harley Bassman of BAS/ML
Harley Bassman warns why, as a result of QE, "yield reaching" shifting from HG to HY may be the "canary in the coalmine for a market tragedy."
"The FED’s purchase of “unhedged” MBS has the theoretical impact of selling over $1 Trillion 3yr into 10yr swaptions. By effectively forcing the Index and TR manager to sell options to replicate the return profile of MBS (and match the yield of the unadjusted Aggregate Index), the FED has found a mechanism to transfer risk from the market to itself. However, as time progresses, the Portfolios of otherwise passive Index managers will become unstable with an increased usage of negatively convex derivatives...The obvious answer to all this is to immediately remove the FED+US Treasury holdings from the Index. But until that time, expect Implied Volatility to decline as replicators sell options to match and index. Also be prepared for this to end badly if too many managers choose this path." - Harley Bassman, ML
Harley Bassman Returns With Extended Perspectives On Implied Vol, The Yield Curve, Convexity, Duration And Much MoreSubmitted by Tyler Durden on 01/22/2010 12:00 -0500
Harley Bassman, who used to run ML's RateLabs is back on the scene, now as part of ML prop (hmmmm) and we are happy to present his two most recent "Convexity Maven" research pieces. Not for the faint of heart - serious curve expertise required. And for those brave enough, an idea for one of the cheapest catastrophe insurance trades: "What to do ? The only reasonable “bear” trade is some sort of mid-dated payer spread. Buying 2yr to 5yr expiries will reduce the time decay issue so you will have more time to wait. More importantly, by selling the OTM payer you reverse the large cost of “dynamic” risk. This will be a huge carry reducer since you would now be paying for the Curve and Volatility risk vectors but selling the Skew risk vector. Since Skew accounts for almost 20% of the cost of a 3yr-10yr 200bps payer spread, this is significant."