Bond Vortex In The Works?

Bruce Krasting's picture


I got an email from a friend who runs money for a hedge fund that got my interest:


may want to take a look at convexity vortex in mbs market and implications...


"Convexity vortex'? What's that about? A bit more from this fellow, I'll call him 'MP':


Some familiar with it say the vortex is 19 bps away..2.2% on ten year treasury, 3% on the CMM..if breaks, MBS holders subject to extension and duration risk. Would now have to increase convexity hedging. Would lead to price gaps and significant selling. With shortage of treasuries due to bernank and co. and low liquidity, could be very disruptive.


That got me interested. A layman's explanation of convexity:

When mortgage interest rates fall, the probability that an individual will re-finance a mortgage increases. When mortgage interest rates increase, the likelihood of a re-financing of the mortgage goes down. Therefore, in a rising rate environment, the average life of a pool of mortgages increases. For example, if a bond fund held Mortgage Backed Securities (MBS) with an assumed 10-year average life, AND interest rates rose, the average life of the MBS portfolio would be extended for a few years. This is convexity. The last thing that a bond manager wants in a rising rate environment is to have the average maturity of the portfolio extended, as this adds to the losses. As a result, MBS players hedge their portfolios against "duration risk" by shorting Treasuries (ten-year paper). The higher rates go (and the speed that rates are increasing) forces more and more of the convexity selling.


MP believes that there is a magic number of around 2.2% on the ten-year bond that will bring out an avalanche of convexity selling. The 2.2% tipping point is very close to where the T-bond sits today.

The fellow who brought this to my attention is a perm-bear on bonds. Given that, I sought out a confirmation from another guy (call him JH) who has been bullish on bonds for many years. JH sits on the bond desk of a big international bank. When I posed the question to the Bond Bull I got a surprising response:


I don’t disagree – I would guess we have a huge concentration of mortgages that would go out of the money at 2.25% 10yr UST, slowing prepays, extending servicer portfolios, bringing on longer duration UST selling ……


So there is a vortex risk in front of us. The weaker the ten-year gets (higher yield), the more selling is required. Is the Vortex going to happen? That depends on the performance of the bond market, AND on how the dealer community is positioning themselves against what is a clear Event Risk. The bond bull, JH, had this to say about the probability of a vortex being reached:


in the absence of a real, organic, self-sustaining recovery, I think this all self-corrects – in the medium term anyway, IF it actually gets to that 2.20% range we could see convexity selling.. but in this environment those higher rates won’t sustain.. in fact, I don’t think they even get to 2.20%, but if they do, and convexity selling ensues, and it’s exacerbated by a ‘thin float’ due to the Fed’s presence, it’s temporary and I’d argue a massive buying opportunity


JH does recognize that there are risks:

generally speaking, and in regards to ‘taper’ of QE, soon as the Fed pulls back, we will see a spike/knee-jerk higher in rates (which I argue we are seeing in ‘anticipation’ of this happening; imo misguided)


Bernanke has recently said that the Fed is in the process of changing the monthly QE purchases. He has said that the amounts of POMO (QE) that is completed on a monthly basis will vary based on "incoming information". From this I conclude that the Fed will, in the coming months, announce a taper of its purchases. When this happens, it's likely that the bond market will "spike/knee-jerk" higher in yield - and when that happens the convexity selling will bring even higher yields.

The Fed isn't going to like that result. They do not want to lose control of the long end of the yield curve. So, if and when the convexity selling hits post a QE Taper, the Fed might respond by increasing the next month's QE in an attempt to drive long rates back down. Bernanke has basically promised to do just that.

What happens if we get this scenario?

1) The Fed cuts the monthly QE from $85Bn to $50Bn,

2) The bond market craps out and 2.2% ten-year is reached.

3) Convexity selling occurs and drives the bond market down another notch to a 2.5% yield.

4) The Fed responds to the disarray in the bond market and announces that in the next month QE will be increased to $150Bn.


This is a realistic outcome. It could happen in the next 90-days. There are two ways that a situation like this plays out. JH, the bull, could be proven right in that bonds purchased with a 2.5% handle will be a good investment. The bond bear, MP, had this to say about the Fed ramping up monthly QE in response to a market correction in yields:


if Fed has to increase buying to stabilize, I would argue it is a very negative development for all markets.


I'm not smart enough to figure how this one plays out. It has a great deal to do with two unknowns - how dealers are positioned, and how the news flow from the Fed progresses over the next month or two. The fact that two guys who trade bonds for a living are well aware of the 'vortex risk' as rates approach 2.2% tells me that all of the bond guys are watching this. So, to some extent, the news is already in 'today's print' for bond yields. The opposite could also be the result. When a market understands that there will be forced selling at a certain level, the market always tries to push to the level where the stop-loss selling has to occur. To me, this suggests that the bond market is going to try to test the 2.2% rate.

I do agree with MP; if the bond market gets soft, the Fed will respond with a very large dose of monthly QE. And I further agree that if it plays out like this - it will prove to be a very negative development for all markets. The inescapable conclusion from this scenario is that QE is FOREVER. Taper talk will prove to be just talk. When players come to understand that the only leg the markets are standing on is endless/massive QE, there will be a shudder of fear.


What's the probability of this playing out as described? I would normally say that the 'worst case' will not happen. But there is something else going on in bond land that is running parallel to the Taper/convexity selling that the US is facing. Japan is looking at a very similar outcome (for much different reasons). As Kyle Bass pointed out last week (Zero Hedge LINK), the promise of 2% inflation and 1% bond yields doesn't have a happy ending. In an effort to cap Japanese bond yields, the Bank of Japan will respond with ever higher amounts of QE. The BOJ has to do this - the entire Abenomics goes up in smoke if the Japanese bond markets puke.


There are forces developing over the next few months that may push the BOJ and the Fed to take some extraordinary actions. That these two big CBs are facing the same potential outcome, at the same time, is troubling for me. I see this evolving story as a possible turning point. The key CB's will have gone from Offense to Defense.

For five-years the CBs have enjoyed being on the offense. They have successfully controlled things so far. But I can't imagine how they can continue to be "successful" when they are forced to defend (versus lead) the bond markets.




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drdolittle's picture

If you make up funny money and buy real stuff with it (taxpayer revenue stream) it's all profit.


tip e. canoe's picture

not a snowball's chance in hell.

he'll leave that for the next stooge.

new game's picture

i ask one question: what if the slowdown (worldwide-due to the massive dollar print) comes full circle so smart and dumb money chases fear into the most deep and liquid pool that exists? he could then taper and report post taper that it is already happening and avoid a black day on the dow.  but hey, wtf do i know.  totally swanish to me. something totally minsky will  suddenly wake us up...

tip e. canoe's picture

too risky to his legacy.    if it blows up in his face, he goes down in history as the man who created the minsky moment.   he'd rather play extend & pretend for the remainder of his term, so he can have one of the Fed buildings named after him one day (or so he thinks).

psychology trumps economic theory every time.

p.s. excellent article bruce.   you've really developed a way to distill complex topics down to easy-to-understand prose.   you should consider becoming a teacher of this stuff.   thanks for the masterclass on convexity.

QQQBall's picture

If you are in Yen and JGBs, wouldn't you rotate to USTs at 2% or 2.20% on the 10-year? You have the currency arb; likely this has been happening - sell strong Yenta, buy USD and then USTs or even US Stocks? I think USTs have more support from Mrs. Watanbe.  

virgilcaine's picture

Decliniining economic activity is the canary in the fed's coal mine. Some things are beyond their control. Narcissist's like to control things but the Entire Global Economy? No Way Jose.

Lets Buy The Dip's picture

some readers in here will say you are wrong!, but i disagree, you are SPOT ON!!!

Just look at the elite, who paniced gold went to high!...yes! what did they effing do? THEY CRASHED GOLD! so they could get back in a cheap price. 


They are sending the market up sky high, no matter how many people say the market si going to crash, it has not. The market will only crash when peole think we will skyrocket. That is how it works. Right now they are doing what they did in 2004 - 2007 right before the crash. Peole thought the market would never go down again, and we crashed in 2007

Right now, the elite are sending the market up and up and up and up. To give investors confidence, then soon they get short and crash the market. They will continue to do this time and tim again. Right now people think the market will crash, so they do the opposite, keep taking it up higher. 1750 will be here on the S&P soon. GET READY!

GMadScientist's picture

Wait until you see them reach for ABCP and find nothing to wipe with!

Thisson's picture

You don't need to be a rocket scientist to know that if the government sets a price floor, it must buy in unlimited amounts.  Thus, QE will never end - Bernanke (or his successors) will have to monetize every single treasury bond out there.  That is why he continually talks about Tapering - because he has to sow the seeds of doubt to keep the bond vigilantes from starting a run on the bond market.

WhiteNight123129's picture


jg's picture

Great column, Bruce.  Clear explanation for us laymen, and reading the thinking of your two friends on opposite sides of the fence is most enlightening.  Thanks!

WTFUD's picture

wish i'd gone to skool.

OnceandForever's picture

Silly thinking without any logic. Further, Faber has been so wrong for so many years it is scary. It is far more likely that Europe will crater and the ten year tests 1%. I remember years of listening to Faber and Gross talking about how rates have "bottomed."   LOL

fonzannoon's picture

the banks were stress tested against everything except a rise in interest rates. 

bubblemania's picture

My UBS Money Manager predicts that something along similar lines will occur this summer. He believes that bond market participants will come to the realization that rates can only go up, the exit will help to continue inflating equities, too levels higher than they are now. In the Fall we will start the cyclical bear market and both bonds and equities will deflate. This will be driven by the FED tapering to exit and dissapointing earning. The thing that could materially impact this hypothesis is all the money that will be flowing out of Japan, where will it go? I'm sure a good part of it will flow into short duration US bonds. This could stabilize the bond maret and keep rates low. 

Thisson's picture

Money managers ("financial advisors") at UBS don't know a damn thing - they're salesman.  They have no fiduciary duty to you whatsoever and, please remember, the people running these firms don't even have enough foreknowledge to know what's happening in their own firm, let alone the bond market.  Look at Jimmy Cayne of Bear, playing at a bridge tournament when his firm failed.  Similar with Dick Fuld at Lehman.  Citibank didn't even know it had liquidity puts in its securitizations.  These are not people you want to take advice from!!!

Fuh Querada's picture

Marc Faber once said something along the lines that the principal product of the current US economy is toxic financial paper, even as college graduates flip burgers and walk dogs. I find this post - intriguing as its content is -  to be a confirmation of his statement.


SAT 800's picture

Yeah, it is. The MBS itself is the toxic paper; or the explosive. The Investment Banks bought themselves some new legislation so they could "innovate"; and now we're in the position of the Polish High School Chemistry teacher who innovated, or invented, as we say, nirto-glycerine. This is a fascinating story; he just kept testing it; over and over, and he actually survived; which is quite surprising. But's it seems to be an open question whether the MBS can be "tamed in the service of mankind", which is what Alfred Nobel supposedly did; or whether we just won't survive this particular invention.  You might say, we export inflation and manufacture explosive financial instruments; we're really everybody's best friend, at this point. (not).

new game's picture

what make your statment so true is that once again the percentage of underlying assets are homes with 95 percent or less

LTVR and FHA leading this on. Add an echo bubble to the mix and I see some trouble brewing again. ben can not and will not let these rates approach 2.25 and yes a rotation will solve his troubles. in his back pocket are euro and japan. the ongoing troubles of growth play out so he can sit back and jaw bone a bit, export his problems to china and watch the cutomers of china squirm(inflation).

true organic growth died in 1971 and 42 years later we are seeing the paper game playing out to its logical convultions...

Lokking4AnEdge's picture

If the Fed keeps on going and the Federal Government can borrow at close to zero interest rates, why keep income tax? Just go all the way and borrow as much as you can and abolish "temporarily" all income tax...did anyone ever think of that?.....................

Al Huxley's picture

The point of ALL of the Fed's actions is to keep the banks solvent (or apparently solvent - with the happy side effect if risk-free money and the concomittant bonuses for the fucking bankers), not to help out the average American.  So sure, they COULD abolish the income tax, but since it won't do a damn thing for the banks, there's no way they ever WILL do that.

Fuh Querada's picture

you would have to fire half of the IRS - not likely to happen

Income tax is control. It's all about control.

Sutton's picture

"We sold bonds to prop up the bond market"   BB

magne13's picture

Exactly where is the convexity risk going to come from when you have the FED willing to put a ceiling on long rates and commit to buy any bonds above that rate?  The capped interest rates after WWII and held them low till 1951.  Granted this is a very different time in America and maybe all the CB's have bitten off more than they can chew and the amount of capital that they have created will now work against them as private forces seem to be taking control.  Actually that makes the most sense, bankrupt the FED and force nationalization onto the treasury much like Fannie and Freddie and then reset the system with new treasury money.  All I know is convexity and any other fundamental interest rate functions no longer apply when you have a regime willing to artificially thwart all natural market forces.  Somehow I think all of this manipulation will bring about huge unforeseen consequences unfortunately it is always the mass population that suffers the most.

magne13's picture

Exactly where is the convexity risk going to come from when you have the FED willing to put a ceiling on long rates and commit to buy any bonds above that rate?  They capped interest rates after WWII and held them low till 1951.  Granted this is a very different time in America and maybe all the CB's have bitten off more than they can chew and the amount of capital that they have created will now work against them as private forces seem to be taking control.  Actually that makes the most sense, bankrupt the FED and force nationalization onto the treasury much like Fannie and Freddie and then reset the system with new treasury money.  All I know is convexity and any other fundamental interest rate functions no longer apply when you have a regime willing to artificially thwart all natural market forces.  Somehow I think all of this manipulation will bring about huge unforeseen consequences unfortunately it is always the mass population that suffers the most.

b_thunder's picture

MP shows the numbers, while JH "thinks" that everything will "self correct."  I bet JH would never work for Ray Dalio, 'cause Ray would ask him in front of the entire staff:  WHY does he think what he thinks.  A few Q&As like that and youf friend JH would be out of Bridgewater and back to the bond desk at a his old bank.

My opinion? Fed will not "taper" from $85 to $50B monthly POMO in a span of 1 or 2 meeting.  That will take more time.  Rates will spike above their "comfort zone" much sooner, which will force them to act.  All the while the Japs are printing and davaluing, which will destroy our multinationals' profit margins:  Kamatsu vs CAT,  Toyota vs Ford, Hitachi vs GE. 

I think Bruce is right.  The Fed will "taper" a bit from 85, but then they'll almost instantly have to raise it to 100 and 150. That will change the perception of who's in charge of the markets.  The Fed POMO will not and cannot end while other CBs are devaluing and while the Governments cannot afford to pay their bills.

Will that be the final race to the bottom? The currency was to end all currency wars?



Tinky's picture

I think that you have touched on a critical point: if the Fed does in fact taper QE (I'm not convinced yet), and are then forced to ramp up almost immediately as the markets take a nose-dive, that will indeed illustrate that *they* have already lost control.

Once that happens, it's time to hunker down.

toadold's picture

If I'm sitting on a big wad of money that depends on moves by the Fed then it behoves me to spend some money to find out what the Fed is going to do. Do you think anybody on the Fed would sell it to my hypothetical self?

How many fund managers I doing that I wonder?

the grateful unemployed's picture

the only question is why would Bernanke taper off $35B if he thought he might have to add $100B the following month? anecdotally i can tell you that housing (assets) are returning to near 2007 levels, there are no buyers of course, but it raises the issue, will banks open up the home equity line ATM? if they do what will participation rates look like, and should these things conflate; mbs vortex, nuevo housing bubble, will the wealth effect trump the rise in interest rates? [ie will home buyers refi anyway to get their hands on the cash], and will that spike consumer spending at the holiday season so cnbc can get out the pompoms. the japanese don't have the same robust housing market, and they aren't good consumers either. if abe was running our show there would be dow 20000 for xmas

Kayman's picture

Thanks for pointing out that the Fed is ultimately backed by the U.S. taxpayer, a rare and shrinking species.

But I have to question "the wealth" effect on the real economy. You cannot spend "wealth". You can only spend cash on hand or credit granted. I look around me and see a lot of people that are  holding a pat hand, and don't want to risk playing in the rigged game.

Bernanke is another book-learned academic, that has no clue how the wheels turn on the ground. His only trick is financialization, and it is a tired, old trick.


the grateful unemployed's picture

if the underlying assets the MBS paper is written against, goes up faster than competing rates, [happening right now] then Bernanke is a genius. he has kept inflation above the fixed income rate of return. not only that but fixed income [widows and orphans]  can get back into the market, which should help juice the economy a bit more. since the housing market is a zombie, it tends to value according to the top end buyers, giving him a further reason to [falsely] claim that housing is recovering, and the economy along with it, but iff joe six pack can go the equity line and get some of that inflated housing money will it work, and as usual it won't work as well for them as it does the 1%. that's when the organ grinder stops.

disabledvet's picture

"the entire State of California" is not the 1 percent. great comment though. you have to throw in massive gains in treasury paper and just outrageous gains in equities...even the dollar now. these so called "academics" have knocked the cover off the ball. the good news for them will be if this really does start a "chain reaction" with sovereign debt imploding and currencies collapsing everywhere. "Now we dance" as Clint Eastwood famously said. the great reset will be well underway and finally all those yield hungry investors will have some juicy returns to look forward too. still not yet though....

the grateful unemployed's picture

the economy hasn't worked for the people obama was elected to help, and that is bernankes undoing. to have any kind of legacy obama has to pay back his liberal constituents. crash or no crash i think fed policy comes down to politics this time

Yancey Ward's picture

Yes, how do we know that they actually hedged convexity risk?

Tyler Durden's picture

Or, there simply will be no "vortex" for one simple reason: in the New Normal market, in which Ben Bernanke is the head risk manager (and thus there is no risk), nobody hedged! At least that is what the most recent TBAC presentaiton (slide 106) suggested.

SAT 800's picture

But doesn't it also imply that there's an instability "hidden" here; if "no one"; or some minimal number of players have hedged; and suddenly the greater number of players come to believe that they should hedge; they'll all try to do it in the same week; and thereby bring on some kind of instability.

ekm's picture

You are still using 'logic'.

Using logic doesn't help in this case.


People behind the scenes making decisions are shitting in their pants and are clueless.

Decision making is more of a lunatic reaction, rather than logic.


QE has not only killed the real economy, but it has incentivised even the allies like UK, Australia, France to do......CURRENCY SWAPS, thus bypassing the dollar.


THIS IS THE DISASTER. THIS IS PANIC. That's why QE is dead and has been dead since QE3 was announced to be ended...meaning can stop any time without notice.

orez65's picture

"... it can stop any time without notice"

Yes it can!!

Quickly followed by a bond market collapse.

Quickly followed by Ben trying to stop the bond collapse by buying any and all bonds.

Quickly followed by Trillions of dollars buying any and all hard assets available at any price.

Quickly followed by hyperinflation.

ekm's picture

Nothing major is going to happen.

The only major think is actually happening right now with QE is ....dollar currency swaps.


fonzannoon's picture

take QE away from the bond market and major things happen.

ekm's picture

Nothing major.

Just few banks die. What's major about this?

fonzannoon's picture

banks have been paying 0% interest forever now. If you have one major bank, just one...that goes down and takes U.S and/or Euro deposits with it, you will see the bank run of all bank runs. Everyone will immediately realize they were lied to. You can kiss the banking system goodbye. 

One major bank, no bailout. That is all it will take.

and here is where you have lost me ekm. It may be a deflationary crunch, but it ends in a currency crisis. That means massive/hyperinflation. the end game is always inflation as people scramble for real assets. 

but forget about the inflation/deflation debate for now. Take down a PD and you take down the banking system. 

ekm's picture

Banking system does not exist any longer. It is simply a huge claim on real assets.


It's either the banking system or the real economy. They are MUTUALLY EXCLUSIVE at this point.


Life has no solutions. Solutions do not exist. Life has only choices.

fonzannoon's picture

The real economy has been dead and buried for a while now. The phony economy has stayed in place because of QE. Take away QE and you take away the banking system, which is very much alive due to QE. One bank goes under and you go from relative calm to instant chaos. That is where this is going, whether it is sooner or later is still up for debate.

ekm's picture

Politicians will be forced to, because the world is avoiding slowly to use dollar.


As I said, there are no solutions in life, only choices

fonzannoon's picture

Be careful with your choice of cash. It may be king for a little while. But then...

Just saw this by the way.

besnook's picture

exactly. why would you have to hedge if the fed is hedging for you?

bruce does bring up another interesting point. if the fed changes its strategy from a fixed amount buyer of crap to a floating buyer of crap then do they end up buying more crap? or less crap? or have they realized the power of buying crap so are incorporating it into a normal part of their operations for posterity because it is such a fun toy to shovel crap?

also, if japan is committed to buying all crap rendered unto them to sustain negative rates to 2% inflation doesn't that give the fed room to buy more(euro) crap? with minimal consequences? to the cbs anyway? afterall, aren't all central banks just playing with a model imposed upon reality that is sound as long as the cash is found to make it work and can't cash be simply printed until infinity? in a sterilized manner since it never actually reaches the street because it is all sopped up by the .1% which only inflates art, private jet and truffle prices?