Negative Convexity

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Lessons Learned From The November Election





Romney's apparent victory in the first Presidential debate was the worst outcome for U.S. stocks, for it gave false hope to a Republican sweeping into the White House. A more gradual acceptance of the November result would give the market a better chance to absorb the news with minimal impact. We are presented with a similar scenario with Washington’s addressing the fiscal cliff.  Optimistic comments about resolving the crisis has spawned gains in equities that are sustainable while losses resulting from downbeat remarks have offered profitable short term buying opportunities.  While much of this price action the past few days has benefitted from typical calendar money flows that will disappear in the middle of next week, some of the positive sentiment arises from the overwhelming belief that both sides can consummate a deal on the budget ahead of the December 31 deadline. The longer investors anticipate such a compromise, the more violently shares will tumble upon recognition that assuaging the crisis with a comprehensive solution will take extra innings.

 


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German TARGET2 Claims Soar To €729 Billion





We have some good news for our German readers: in the month of June, your implicit cost of preserving the Eurozone (read the PIIGS) via TARGET2 funding of current account and various other public sector deficits and imbalances amounted to only €1 billion/day, down from €2 billion in June. We also have some bad news, which is that Europe's negative convexity ticking inflationary timebomb (why inflationary: Why Germany's TARGET2-Based Eurozone Preservation Mechanism Is Merely A Ticking Inflationary Timebomb), which guarantees that with every month in which nothing is done to undo the Buba's onboarding of liquidity risk, the risk for an out of control implosion of German, and implicitrly all European monetary institutions, rises exponentially, and just hit an all time high of €729 billion. To everyone who naively believes that a deus ex can come out of stage left and somehow reverse this guaranteed loss to German taxpayers (sorry: no free lunch) in the form of even more guaranteed inflation down the road, we suggest you short the chart below, somehow (and when you figure out how, let us know, so we can do the opposite).

 


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The "Formerly Brilliant Dimon" And Maxine Waters Debate Delta Hedging And Negative Convexity Live





As if last week's bought and paid for by JPMorgan media circus in the Senate was not enough, in which Jamie Dimon played several bribed muppets like a fiddle, today we get part two. Momentarily, the Committee on Financial Services will pick up the baton where the Senate left off, and confirm to everyone that the people who lead this country, at least on paper, are some of the most incompetent, and outright clueless when it comes to financial matters. The same matters that have led America to the Second great depression, which has so far been prevented from wiping out 20% of the economy only courtesy of Bernanke's relentless money printing. Dimon's testimony, which is a replica of last week's, can be found here. In other news, Jamie Dimon is furious he never bribed Maxine Waters before. Now he will have to explain introductory math for absolute idiots. Karma is a bitch.

 


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So How Are JPM's Prop "Counterparties" Faring?





We already know that JPM has lost billions on its prop trade, and as suggested earlier (and as the FT picked up subsequently), JPM's prop desk (not to mention its actual standalone hedge fund, $29 billion Highbridge, which nobody has oddly enough discussed in the mainstream press yet) is so large that unwinding the full trade, as well as all other positions held by the CIO, would be unwieldy, allowing us to mock "the fun of negative convexity - especially when you ARE the market and there is no-one to unwind the actual tranches to." The FT then phrased it as follows: "I can’t see how they could unwind these positions because no one can replace them in terms of size. It’s a bit of the same problem they face with the derivatives trade," said a credit trader at a rival bank. "They pretty much are the market." Which actually is funny, because if the media were to actually read a paper or two on how the market works, and puts two and two together, it just may figure out that the biggest beneficial counterparty for JPM is none other than the Fed, using the conduits of the Tri-Party repo system. But that is for Long-Term Capital MorganTM and its new CIO head Matt "LTCM" Zames to worry about. In the meantime, a question nobody has asked is how have the purported JPM counterparties, the most public of which are BlueMountain and BlueCrest who leaked the trade to the press in the first place, and are allegedly on the other side of the IG9 blow up doing. Well, according to the latest HSBC hedge fund update looking at the week ended May 11, not that hot.

 


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It's Not Over Yet For JPM





IG9 10Y spreads re-surged today and were very choppy into the close as they broke back above 155bps (at 155.5/157.5bps now) for the first time since Mid-December with a 31% rip in the last two weeks. This fits perfectly with our ongoing thesis of this being a tail-risk hedge (not a simple 'spread' as other ignorant commentators presume) whose risk management has exploded in their face. While the skew (the difference between the index and its portfolio fair-value) has collapsed and arbs will be happy and likely exiting - the same correlation shifts (that we discussed earlier) that drove the big bank to sell more and more protection into a spread compressing market are now back-firing as systemic risk re-surges and the correlation shift is forcing them to buy back more and more protection into a spread decompressing market. Oh the fun of negative convexity - especially when you ARE the market and there is no-one to unwind the actual tranches to.

 


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Is High Yield Credit Echoing 2011's Equity Nightmares?





For the last month or so, despite ongoing fund inflows, high-yield credit's performance has been generally muted. Compared to the exuberance of the equity market it has been downright flaccid and given how 'empirically' cheap it is on a normalized spread basis through the cycle (and the fortress-like balance sheets we hear so much about) some would expect it to be the high-beta long of choice in the new-new normal rally-to-infinity. However, it is not (and has not been since late January). There are some technical factors including a bifurcated HY credit market (between really 'good's and really 'bad's and illiquids and liquids), low rate implications on callability and negative convexity affecting price but the lack of share creation in the HYG (high-yield bond) ETF also suggests a lagging of support for high-yield credit. This is a very similar pattern to what was seen in Q1/Q2 last year as equity kept rallying away from a less sanguine credit market only to eventually collapse under the weight of its own reality-check. European credit and equity markets are much more in sync together as they have fallen recently but financials in the US exaggerate this credit-signaling-ongoing-concerns trend while equity goes on about its bullish business. Another canary dead?

 


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Do High Yield Bonds Know Something Stocks Don't?





As the S&P 500 reaches new multi-year highs and VIX touches multi-year lows, there is one rather large and risk-appetite-proxying market out there that is not as excited. The high-yield bond market has seen record in-flows dropping off recently and for the last four-to-six weeks high-yield spreads, yields, and bond prices have been very flat as stocks have surged ahead. Despite US earnings yields at near-record highs relative to high-yield bond yields, we see little pick-up in LBO chatter suggesting a notable preference for higher-quality junk credit (and/or lack of belief in sustainability of earnings yields) and the recent 'dramatic' outperformance in investment grade credit is a notable up-in-quality rotation (as well as early spread-compression reaction to Treasury weakness recently) that strongly suggests less risk appetite among real money managers (given how 'cheap' high-yield appears across asset classes). Lastly, the ratio of HY bond prices to VIX is near its extreme once again, something we saw occur before the risk flares of 2010 and 2011 surrounding the end of the Fed's QE sessions.

 


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Market Round-Trips To Yesterday's Open





Whether it was FX majors, the Treasury complex, or the economically-sensitive commodity markets, the 'negative' shift from yesterday's open (USD up, TSY yields down, Commodities down) plateaued overnight and retraced throughout the day today. Equities and credit however managed to make new highs (while all these other risk-related assets did not) as they stayed in sync for the afternoon (double-topping on lower volume) as financials outperformed (MS +5% for example) on what we can only imagine was Greek rumors (which later proved as usual to be completely false). Oil dropped markedly into the close, heading for $97 as Gold remains the week's winner (though Silver and Copper won on the day). The USD is flat (leaking higher in the late day) to yesterday's pre-market after trying and failing at 1.32 against the EUR (which is the underperformer vs USD on the week for now -0.48%). Treasuries sold off, adding 3-7bps across the curve (though still lower yields on the week) and while 30Y underperformed, 2s10s30s did not move much as the rest of the curve pivoted. The last 30 mins of the day saw ES pull back from its lonely highs to test VWAP (and IG and HY credit also fell with it) as open to close, credit underperformed, and cheap hedge IG was moving more negatively than beta would suggest. By the close, ES had pulled back (lower) to converge with CONTEXT (proxy for broad risk assets) and fell below VWAP as once again average trade size picked up significantly to the downside.

 


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Is High Yield Credit Over-Extended?





"Reach for yield" is a phrase that never gets old, does it? Whether it's the "why hold Treasuries when a stock has a great dividend?" or "if this bond yields 3% then why not grab the 7% yield bond - it's a bond, right?" argument, we constantly struggle with the 100% focus on return (yield not capital appreciation) and almost complete lack of comprehension of risk - loss of capital (or why the yield/risk premium is high). Arguing over high-yield valuations is at once a focus on idiosyncrasies (covenants, cash-flow, etc.), and technicals (flow-based demand and supply), as well as systemic and macro cycles, which play an increasingly critical part. Up until very recently, high yield bonds (based on our framework) offered considerably more upside (if you had a bullish bias) than stocks and indeed they outperformed (with HYG - the high-yield bond ETF - apparently soaking up more and more of that demand and outperformance as its shares outstanding surged). With stocks and high-yield credit now 'close' to each other in value, we note Barclay's excellent note today on both the seasonals (December/January are always big months for high yield excess return) and the low-rate, low-yield implications (negative convexity challenges) the asset-class faces going forward. The high-beta (asymmetric) nature of high-yield credit to systemic macro shocks, combined with the seasonality-downdraft and callability-drag suggests if you need to reach for yield then there will better entry points later in the year (for the surviving credits).

 


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Silver Backwardation Doubles Overnight





Yesterday we correctly predicted that the entire 10% silver correction would be momentarily taken out as the Comex news is properly digested. And so it continues - as silver is once again pennies away from $50 and a fresh new nominal all time high, we take a quick look at the futures curve where as expected the backwardation is confirming the "negative convexity" (yes, yes, we know silver is not a duration security) once the $50 stops are taken out will send silver surging to unseen before levels (which also considering it will be at a new record over $50 is pretty much intuitive). In the meantime, the chart below is the worst nightmare of anyone still holding short silver positions. While the near-far contract backwardation was about $0.75 yesterday, it has since doubled in less than 24 hours. We can't wait to see what surprising nuggets the Comex will bring us today.

 


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Observations On The Latest Debt "Inflection Point", And Why Bernanke Has At Most 5 Months In Which To Announce QE3





Yesterday on Tom Keene's always informative show, two of the world's most important economists, Goldman's Jan Hatzius and BofA's Ethan Harris presented their respective defenses for why GDP in 2011 would rise by nearly 4% as per their recent predictions. The straw man for the upside case: recently adopted fiscal stimuli which, however as David Rosenberg notes, are not really stimuli as much as lack of governmental disstimuli. Yet what is interesting is that both ceded that both employment and housing, the two key traditional drivers of economic growth and prosperity, would likely continue deteriorating, with employment ending the year over 9%. In other words, all growth in 2011 will be predicated upon very much more of the same: transfer payments and government stimulus (not to mention inventory accumulation) especially in the form of incremental debt to offset consumer deleveraging. No surprise there. After all the only reason why the economists of the world have expressed an unprecedented amount of bullishness in recent months is that the US is currently experiencing a rare confluence of both fiscal and monetary stimulus: an even that last occurred in March of 2009. The issue is that as we have noted previously, the benefit from the fiscal stimulus has already been negated by the jump in oil and other commodity prices, whereby the token weekly paycheck increase has been more than offset by gas price increases, while the monetary stimulus is already priced in, and absent rumors of another episode of QE in advance of the June end of QE2, the temporary stock market strength will quickly turn into weakness. Which leaves us with the hangover effect of federal deficit... and its funding. The chart below presents some interesting observations in this regard, and also makes us wonder just what will happen to risk assets if Bernanke does not leak the announcement of QE3 by May at the very latest.

 


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As Mortgage Rates Go Parabolic, Home Prices Will Soon Be Latest Shoe To Re-drop





The negative convexity loop in mortgages is starting to see casualties left and right. The most recent read on the 30 Year Cash Fannie Mortgage rose by 11 bps overnight, and by a stunning 1% in the last month. At 4.703% the prevailing wholesale mortgage rate is back to the highest it has been since May 2010. And while some have speculated that this inflection in rates would have been sufficient to get Americans to jump on refinancing their mortgages, attempting to catch low rates while they can, the jump has been so powerful that to many the now incremental 10% loss in purchasing power does not make a purchase equitable any more. As a result, ceteris paribus, home prices will have to decline by about 10% to compensate for the pick up in rates in just the last month. And since the jump in rates on a duration adjusted basis is even more painful, there will be increase selling of comparable securities as managers look to shed a sudden surge in duration, leading to a further spike in yields, and so forth.

 


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Deflationists Take Note: Bernanke Succeeds In Offsetting Shadow Banking Collapse





The biggest piece of news in Thursday's Z1 statement was not that consumers continue to deleverage, that corporate cash levels are at $1.9 trillion (of which $1 trillion is financial and half of the rest is held offshore: maybe instead of copying Zero Hedge charts, the WSJ could have actually focused on the story behind the headlines) or that the stock market continues to be the only manipulated delta in household net worth (even as wealth in real terms is dropping). A far more relevant and important data highlight has to do with the only thing that actually matters for the reflation of the monetary bubble: namely the fact that the contraction in the shadow banking system is continuing. Or so was the conventional wisdom. As of September 30, Bernanke has successfully stopped the net decline of monetary aggregates even when including the massive shadow banking system.

 


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What The Rout In MBS Means For Pimco And Broader MBS Investor Alternatives, As The Market Wakes Up To Risk





Wonder why various PIMCO funds are getting hammered over the past week? Simple: the fund's recent push into mortgages, especially on margin, has backfired, and courtesy of the surge in mortgage rates which we highlighted yesterday, has left the world's biggest bond fund, second only the Federal Reserve, hoping for a last minute Hail Mary (Pimco can't print money unlike the former). As a reminder, while Pimco's TRF is positioned well to benefit from the steepening in the 2s10s courtesy of its 4.86 effective duration, we are unsure how the massive flattening of the 10s30s is impacting the firm. What we are absolutely sure of, is that the plunge in MBS prices in the recent week has left the fund gasping for air. Recall that the TRF has increased its MBS holdings by $50 billion in the prior two months (and likely continued in November), which is why the entire rates complex must prevent the ongoing rout in 10s and 30s as otherwise the negative convexity threatens to force an avalanche of selling first by the PIMCOs of the world, then everyone else. We present some very relevant commentary out of CRT on the MBS crunch conundrum.

 


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