With Fed Holding 31.6% Of All Treasurys, The "Short Gamma" Pain Trade Is The One To Watch
A week ago, the Fed owned 31.47% of all 10 Year TSY-equivalents. One week later, this number has risen to 31.59% as of the most recent Fed balance sheet update.
Shown another way, the amount of ten-year equivalents held by the Fed increased to $1.663 trillion from $1.648 trillion in the prior week, which reduces the amount available to the private sector to $3.602 trillion from $3.589 trillion in the prior week. There were $5.265 trillion ten-year equivalents outstanding, up from $5.237 trillion in the prior week.
While we won't repeat what we have said countless times already: that the Fed is concerned that as it consumes more and more of the bond market, it will impair the normal functioning of a private market already precariously illiquid (as the TBAC reminds the Treasury Department at every chance it gets), we will note that not even the Fed has any idea how to proceed, hence the confusion over whether Ben will Taper, or he won't. The reason why the market is confused: Bernanke himself is confused, and doesn't have the faintest idea of what to do.
And with the rising uncertainty, the biggest trade driving the rate complex, and by implication, the entire risk complex, is being put (no pun intended) to rest. As BofA explains: "the FOMC (the biggest buyer of duration and convexity risk in the world) is long the option to taper asset purchases (and eventually raise rates) if the data improves. That leaves the market short the option that the Fed may decide to taper. The market has looked to hedge this “short gamma” exposure by selling duration and buying vol."
So the closer we get to the Taper date, and the end of QE, the greater the uncertainty that future duration and convexity will be consumed by the Fed, and as a result of an increasing shorter gamma position, the more duration selling and vol buying will be experienced, until either the market finds a new equilibrium or cross-asset correlations (with equities already deeply stretched) finally snap.
The full Bank of America note:
One of the key catalysts for the recent rate selloff, in our view, has been the unusually high degree of uncertainty about the outlook for Fed policy. The FOMC under Bernanke’s leadership has spent the last few years trying to refine and clarify its communications, which had the effect of reducing term premiums and pushing rates and rate vol lower. Since May, however, rates have risen and vol has spiked as the Fed’s reaction function has become less dovish and much more uncertain.
We see a number of reasons for the increase in the market’s perception of Fed policy uncertainty in recent months.
- Late last year the Fed changed both of its main tools (the balance sheet and forward guidance) from calendar-based timelines to outcome-based thresholds. As a result, the degree of uncertainty about the future path of Fed policy has increased, reflecting the fact that that the economic outlook is inherently uncertain. Said differently, the FOMC (the biggest buyer of duration and convexity risk in the world) is long the option to taper asset purchases (and eventually raise rates) if the data improves. That leaves the market short the option that the Fed may decide to taper. The market has looked to hedge this “short gamma” exposure by selling duration and buying vol.
- The composition of the FOMC is set to change in the coming year, not only because Chairman Bernanke will be replaced but because 3-5 Board members will need to be replaced. Moreover, doves Evans and Rosengren will be replaced on the Committee by hawks Fisher and Plosser while centrist Cleveland Fed President Pianalto, a voter in 2014, is retiring. For details see Liquid Insight: New faces for the FOMC.
- Even the current set of participants can’t seem to agree on whether the recent rise in rates is good or bad; whether lowering the unemployment threshold would help or hurt; whether the low level of labor force participation is cyclical or structural; or to what extent growth and inflation are set to accelerate. One of the few issues on which there is agreement: the minutes suggested that the FOMC does generally agree with the Chairman’s conditional timeline for winding down purchases over the next year.
- Comments from a number of senior Fed officials have suggested that a key reason they sought to scale back the market’s expectations for QE this spring was concern about rich asset valuations and excessive investor leverage. Indeed, the Fed began to warn the market about their plans to taper despite weak GDP growth and well below-target inflation. This implies that the FOMC is more concerned about the costs and unintended consequences of asset purchases than the market believed when QE3 was announced last year. Uncertainty about the Fed’s view of the cost-benefit tradeoff has further clouded the outlook for Fed policy, resulting in higher risk premiums.
In our view, there is little the Fed can do in the short term to reverse this dynamic, but knowing who will be nominated to lead the Fed in the next phase of its unprecedented monetary policy efforts would certainly help. In the meantime, we believe rates are likely to remain biased higher due to bearish technical factors (bond fund outflows, declining bank demand, reserve manager selling, etc) unless US economic data takes a decided turn for the worse.
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