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Bond Vortex In The Works?
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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I'd like to be a fly on the wall at Hayman Capital. Kyle Bass and crew own alot of non agency MBS.
Yes; I find this very puzzling; I suppose it's just one of the thousands of things I don't understand. Kyle Bass is certainly one of the smartest people I've ever listened to; and famously he thinks outside the box, and he's quite contrarian; I don't understand why he's so sure it's a good idea to have this stuff in his portfolio; it seems to me to be a kind of very dangerous stuff; that could become volatile at any moment. I can only suppose he understands this much better than I do, but I can't grasp it really.
His public statements about owning MBS go back about 2-3 years on the assumption the government and the fed would support housing. So he was basically front running imo.
Now with the fed threatening to exit QE, you've got to wonder if he's already made his exit.
he also has clearly stated many times, including recently, that interest rates can never go up.
The US is in the same boat that Japan is in, if interest rates go up the currency crashes.... so the Fed will not willingly raise interest rates....
If interest rates increase the Fed will be forced to "drain liquidity" out of the monetary base. This would mean not only stopping QE but "undoing" the QE 1,2,3... this is not possible with out losing complete control of the monetary policy and the game is OVER.............
I am sure Bass has considered this and has a "safety net"(armed fortress in the middle of Texas........ with gold and other physical assets) under his wealth (not to say he will not sustain losses because he will).. you don't win all the bets you place!
In several interviews Bass has warned of a major war to break out......
"History does not repeat itself, but it does rhyme." Mark Twain
Yeah... I'd like to believe EKM's theory, but the moves in the bond markets is signaling where we're headed.
I've had this picture in my head of Ben Bernanke pointing a gun at the markets, saying "sell off or I'll do it." Now with the Japanese bond market melting down and rates rising here, anymore threats of ending QE is in effect the Bernanke pointing the gun at himself.
Won't the floating rate notes the Treasury are going to start issuing in 2014 bring the rates down even more or at least allow the Treasury or FED to rig the rates like Libor to keep from the bonds rates spiking and killing the government at the same since when the rates go too high they will in essence default on existing debt payments if that is the case?
I will re-read and re-valuate at a later date but isn't the problem when the Fed announces something it is constantly being front run? "so what will be sold should the Fed start winding down the APP?" seems easy enough: "that guy in Korea started squawking first." also...there was a problem I recall of "early re payments" back in the 2000's housing bubble as a reason for why banks...not the Federal Government which is doing this now...had to be extending credit at ever lower rates. What is the risk to principle here again? (very little if we're talking a working cash flow positive asset?) That yields DROP too far too fast? That's a risk to the BALANCE SHEET not to the value of the underlying asset. "a glance sheet recession" they call it. Hmmm. "how is QE creating internal demand again"? I fail to see it...STILL. Dollar getting uber strong now...folks are way over extended in equities...globally in my view. We need a sell off here if the bull market thesis is to remain in tact...unless of course a huge recovery can be pointed to in something other than tax revenues which is well underway as well.
Of course, the Fed also owns quite a few of these MBS. We know they don't hedge!
the Fed's hedge is the US taxpayer - the same people who pay Bernanke's salary and pension and luxo health care
Thanks for this T. You provide info that the market is unhedged. To me, that confirms that a vortex is possible. At some point someone in MBS land will blink (Pimco?)
Everyone loves bonds, they are long and unhedged. That sounds like Apple at $700.........
what do you mean they aren't hedged? ridiculous. "they have the Central Bank." it simply prints...and buys the debt. to date the Fed has been nothing but rewarded for this outrageous behavior. if Bernanke monkey hammers those rates to below one percent it won't take much private banker bucks to get the economy to a point where the deficit becomes a surplus. "then they can exit" and so can i. the fly in the ointment is the recovery itself...equities, real estate...they're creating (VERY mild) pricing pressures. the easiest solution to any deflation is to build human history's biggest Army and Navy. "there goes your surplus labor." that will force normalization by the Fed...we'll probably never see a gold standard again of course but it should make you gold bugs jump for joy...but it will cement a dollar hegemony for quite some time. "that's what these folks are thinking about." now how "their actions can blow up the country." all eyes on your "vortex" in Japan Bruce. Move along...
Exactly, BK is correct, the biggest is when everyone is on the same side of the trade which leaves no new marginal buyer, if hte Fed stops buying what happens?
Now the tricky part is that the Fed buying termporarily makes things look a bit deflationary is the curve is flatter, but long term there is no chance the base money is not going to enter the circulation.
That means Treasuries are either poised to an accident or destined to a bear market.
As for the argument of Tyler it is basically, everything will be fine because the Fed is in control and so if everyone is swimming naked, no worries the Fed is the chief risk manager.
The strategy of the Fed can not work. Why? Because the second round effect of pushing yield down is actually pushing them up. You need to print money to repress yield, so short term the Fed wins, but eventually the base money comes back in the economy, raises inflation expectations and kicks the bond market in the balls.
And, basically, yes; I agree. that's my position exactly. "Everyone loves bonds"; everyone loves their high school girl-friend too; even tho she's now 55years old and weeighs 160lbs.; what they're doing is driving by looking in the rear view mirror. I'm only interested in being contrarian; the only reason I want to know, and I believe it's true, that "everyone loves bonds" is to short the rallies, and keep on doing so; It's profitable, and that's all I need to know about it; thank God; because frankly I don't even understand half this stuff that bond experts love to go on and on about; but I can see on a one year, or two year bond chart; that is not a bull market. It was. But it's not now.
Well, as far as I'm concerned, the Bull Market in Long Term Treasuries is over. If you look at ZB on the CME as a weekly chart you can see the lovely couble top; which I shorted when it became a double top; and last year, there was another double top that spanned a couple of months, but it was higher than this recent double top. So, as I posted at that time, last year; as far as I'm concerned the bull market is over; because it's easier now to make money shorting the tops of these rallies than any other tactic. A market that doesn't make any new highs for over a year and keeps printing these lower and lower impenetrable upper limit prices which are signalled by the spike double tops is a bear market. I mean, as they say, in trading at least; "The bears are the ones who have the money made". I feel certain and justified in saying that all this Bond Bullishness is just a very human failing; the idea that what happened for a long time will continue to happen, I don't know what you call that; the continuity theory, or something; but if you just look at the price chart you'll see something that doesn't meet the criteria of a bull market. It just doesn't. It's meets the criteria of a Bear Market. So, personally, I just don't listen to bulish comments about the Bond Market; and best of luck with your friend's "buying opportunity"; but I think he needs to go back to basics here and remember that markets are driven by fear and greed; and fear is stronger. His big buying opportunity could easily turn out to be just the frist stage of a mudslide; IMO.
I thnk in a logical world bonds would be dying. With the fed buying everything (and will continue to do so) bonds will hold steady (rates dampened). The currency you're repaid in will be worth less and taxed on its "gains". It's a loser to buy but likely a loser to short too.
The term you're looking for is Recency Bias, and it's very powerful.
I should have been clearer - a lot of the MBS market is owned by the Fed and foreign central banks. So the question is: What percentage of the MBS beyond, say, a 7-year maturity, held in private hands is actually hedged?
Bonds specifically US Treasuries are backed by the most precious metals of them all and it is not gold and silver either, it is brass and lead. That is why you don't short them...... There will be very bloody repercussions if you do and you aren't hedged accordingly in the same metals.
Misconception. The only reason to biy bonds is to get free juice from the fed. Period. It has nothing to do with non financial issues.
Maybe Benny and the Inkjets are aware of this potential issue and have started the taper talk to help incite a correction in the equity markets (which have been diverging from macro data anyway) which typically coincides with bond buying as the money flows out of equities and into the perceived safety of bonds. The markets pavlovian response to the end of QE has historically been for equities to sell off, is this time any different?
So talk about ending QE to incite equitiy market correction with the expectation bond yields will be driven down 'organically'. When equities get to a level B&Co perceive to be problematic for economic activity, boom, QE ramp up announced, pavlovian response to buy equities back in effect. Wash rinse repeat?
Edit: Further, there may not have to be any more actual QE at that point as the economy is recovering pretty well, so a floor in equities will more than likely be found on its own or maybe when B&Co. get uncomfortable they can just from jawbone of QE without any follow through. At that point the bottom will be in. Our unemployment rate is 6.4% (in FL) BTW.
So the economy is recovering pretty well, eh? Have you bothered to look at any actual data, or are you basing this on the headlines you read? The economy is hanging on by its teeth. This is reflected in macro data such as manufacturing, to name one, and indicators such as the price of copper and lumber, which are both in bear market territory. 48 million people on food stamps, and rising, employment participation rate at 1980 levels. There are bubbles everywhere. Systemic risk right now is higher than it was in 2006.
But yeah, unemployment, according our trustworthy government resources, is 6.4% in FL. Everything's peachy.
I base it on the economy in my area which is doing quite well. If you call a northern unionized rathole home, I understand your concerns. There are obviously some areas of this country with big time competitiveness, corruption and entitlement issues. At some point the people in those areas will have to come to terms with the mess they have created. See Detroit and Southern Europe for some foreshadowing of what some of those areas have to look forward to. We will be soon be importing construction workers from the northern states if it is not happening already. There is construction going on all over the place, with several billion dollars more in the design and permitting pipeline. Sorry to rain on your parade but things are in fact going quite well down here.
Construction in FL? Great....just what we need more of. Talk about a missallocation of capital yet again. Things are going well down there just like in 2005/2006.
this series of posts tells me "big gamble" if you place ANY bets!
unless of course you have inside info...
so lets sum this up-90 more days of trading desk profits at jp and the squid...
I live in a northern unionized rathole, and the economy is kicking ass. It's a phony economy though and if the fed ever tries to back off the credit freeze that takes place will stop everything in it's tracks. If the fed does not back off the dollar is screwed and the economy will just drop dead. It's quite the conundrum.
yes and a rise of even a 1/4% in interest rates could wipe out the feds balance sheet. there's the logical answer and the practical answer. since the feds balance sheet would then become the property of the taxpayer.
Why hedge with T notes when you can always sell your mortgages to the Feds?
The FED balance sheet is rock solid with purchases that are so in the black that rates would have to rise for ten years for any sort of trouble. China and Japan and our FED have been buying bonds for 30 years. All at a profit today.
What profit? They print up some funny money and trade it for a US IOU. That's profit?