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Harley Bassman: "The Fed Is Trying To Land A Jumbo Jet On A Football Field"
Once upon a time, one of the best sell-side analysts in the MBS space was Merrill Lynch's "Convexity Maven" Harley Bassman: he was so good, in fact, he was quickly soaked up to the buyside, or at least the prop-trading side, when several years ago he left Merrill to join Credit Suisse as a prop trader. It was here that he provided some insightful trade ideas such as "The "Anti-Widowmaker" Trade: Get Paid To Wait For The Japanese House Of Card To Collapse" and previewed the "Inevitable 'Taper'" at a time when most still didn't think the Fed was running out of paper to monetize. Then, about a year ago, Bassman disappeared again, only to reappear in a new capacity at recently-troubled bond manager Pimco. It is from here that following a year-long silences, he has just sent out his latest letter, in which he picks up on his favorite topic: implied volatility in rates, and the arbitrage opportunities it provides courtesy of epic risk mispricing in the current quote-unquote market, courtesy of the Fed's 6 year+ centrally-planned manipulation of, well, everything.
From Harley Bassman
Financial Market Cognitive Dissonance?
- Presently, the financial markets are confronted with two conflicting pricing structures: a U.S. dollar yield curve that anticipates a significant increase in interest rates over the medium term, and an options market that offers “rate insurance” at the lowest prices in decades.
- Markets may appear confounded by cognitive dissonance, but forward-looking investors can peer through the fog: A return to a more recognizable risk/return profile, even if market returns are lower overall (as may well be the case over the secular horizon), could help investors more confidently align longer-term objectives with strategies.
?In psychology, cognitive dissonance is the mental stress or discomfort caused by holding two or more contradictory beliefs at the same time, or from receiving new information conflicting with existing beliefs, ideas or values.
Presently, the financial markets are confronted with two conflicting pricing structures: a USD yield curve that anticipates a significant increase in interest rates over the medium term, and an options market that offers “rate insurance” at a historically low cost.
An investment conundrum …
Woe to the investor who fails to heed the admonishment: “Don’t fight the Fed.”
And so it has been for the past five years that the Fed has implemented a grand scheme to increase monetary velocity via financial repression (zero interest rate policy, or ZIRP, and asset substitution) to create inflation, depreciate nominal debt and delever both the public and private economies of the United States .
Yet we have all seen this movie before; we know that the calm financial landscape the Fed has engineered will at some point become roiled. But let’s be clear, this is not a dire prediction for calamity, in our view, it is just a notification that today’s placid financial market will eventually return to a more normal risk profile.
The yield curve appears to be fully awake to the possibility that the Fed could lift the heavy hand of financial repression – at least that is one interpretation of a still-steep yield curve. While substantially flatter than its peak earlier this year, the current (as of 8 October) level of the benchmark two-year Treasury versus 10-year Treasury spread of 176 basis points (bps) is well above its 20-year average of 124 bps.
Yet this notice remains undelivered to the options market as the cost of interest rate insurance, quoted short-hand as the measure of implied volatility, is still near its “forever” low. Currently (as of 8 October) a three-month option on the 10-year swap rate sports an implied volatility of 69 bps versus its 20-year average of 105 bps. To apply some context to this statistical gibberish, an implied volatility at this level suggests a daily move of barely 4 bps. A more salient interpretation: Such a level of implied volatility creates a “break-even” range of less than +/? 16 bps for an entire month – a rather confounding number when one considers that the 10-year rate traversed 104 bps in two months during last year’s Taper Tantrum.
Some may view the shape of the yield curve and the level of implied volatility as two independent and separate observations, but in fact they are historically well-linked. While it might be easy to rely upon charts and graphs to support this notion, instead I would like to present a heuristic parable as to why the linkage between these two risk vectors may soon revert toward their more normal relationship.
In Figure 1, the eggplant line is the yield spread between the two-year swap rate and the 10-year swap rate while the avocado line is the level of implied volatility for a three-month expiry option on this same 10-year rate. While “conjoined twins” they are not, it is clear that these two risk vectors mostly have traversed a similar path over the past 20 years, at least until recently. While we might engage in a series of compounding differential equations to support this relationship, instead let’s just apply some common sense.
A forward rate is often described as the market’s “prediction” of where interest rates will be at some given time in the future. Let me please dispel you of that notion: No one paced the corner of Wall Street and Broad (or the local Newport Beach Starbucks) taking a poll. A forward is simply the mathematical discounting of the spot curve to produce an “arbitrage free” price, no more, no less. That said, I will concede that the spot curve does contain meaningful information about how market participants value risk, and as such, there is significant value to be gained by analyzing the shape of the forward surface.
In a brief digression for those who are unfamiliar with the concepts of spot and forward rates, let’s consider this hypothetical decision process. You have been entrusted with investing your mother’s retirement funds. You can buy either a one-year CD at 2% or a two-year CD at 3%: Which do you choose? The action you take depends upon where you think you can purchase another one-year CD next year to make this an apples-to-apples comparison (so both investments have a two-year horizon). You would take the former investment only if you were confident the one-year “forward” CD could be purchased at 4% (or higher). (2% for the first year plus 4% for the second year is roughly equal to 3% for both years.) In broad strokes, this is the definition of a forward rate: It is the level of rates in the future that creates indifference today.
Back to our main point: When the spot curve is flat, the forward curve will also be flat at about the same level. However, when the spot curve gains some shape, forward rates will diverge from spot rates. The steeper (or more inverted) the yield curve, the greater the distance between the spot price and the forward price.
Until Brian Greene can find a wormhole into the multi-verse, time only can travel forward and the future must become the present. With no consideration as to whether the forward grinds to the spot or a spot price heads to its forward, a larger spread reasonably implies a greater uncertainty of the outcomes. And since implied volatility tends to be a function of uncertainty (risk), option prices tend to rise in conjunction with a steeper (or more inverted) yield curve.
The current situation is nearly the dictionary definition of cognitive dissonance: the discomfort experienced when one tries to hold two contradictory beliefs at the same time.
The yield curve is presently so steeply sloped that the one-year rate is implied to double in six months and the two-year rate seems slated to triple in two years. Even the less volatile five-year rate might be over 100 bps higher as spring turns to summer in 2016. Yet despite this uncertainty embedded into the yield curve, most measures of implied volatility are near their “forever” lows.
The hemoglobin line in Figure 2 is a cousin of the well-known MOVE Index (the VIX of interest rates). Annotations show the events that locally drove volatility over the past 20 years; the current reading of 63 is extraordinarily low. Moreover, even a cursory glance would inform one that on the few times this index has breached 60, some sort of significant event has soon followed to pressure option prices higher.
While anecdotal, this evidence suggests there is a limit as to how far the shape of the yield curve can diverge from the level of volatility. The malibu line in Figure 3 charts the ratio between the difference of the two-year rate today and one-year forward (often called the “carry”) and the cost of a one-year option on the two-year rate.
A Wall Street aphorism for option traders describes the “three-to-one rule.” Here, one measures the interest rate income embedded in the yield curve (the “carry”) and compares this to the cost of an option of similar tenor. When this ratio reaches three to one, the trader should buy the option.
What is the source of this rule? Let’s skip the math and just consider this as a game. Assume one has no opinion as to whether the spot or forward price will be realized in the future. So if asked to weigh the odds of either outcome, the only rational ex ante guess is a “coin flip.” Unless you can employ a trick coin, the fair payoff for a “flip” should be two to one. As such, it is completely anomalous that one could buy an option for one dollar that will pay out three dollars if the rate structure remains unchanged (forwards accrete to spot). In essence, one is being offered a three-to-one payoff for a two-to-one risk. The option price is simply too low for the risk embedded in the yield curve. It is this notion that underpins the usually tight correlation between the yield curve and implied volatility, and why payoff ratios tend to remain below two to one.
As much as it distracts from a good story, the fact of the matter is that it is never “different this time.” Risk and return are tightly linked except for those rare periods when investor emotion overwhelms financial concentration. While one could justify the present yield curve/volatility dynamic as a manifestation of the Fed’s efforts at “guidance,” I would retort that while it may be possible to land a jumbo jet onto a football field, it is still highly unlikely.?
While we can debate when the journey to the terminal federal funds rate will begin, what may be more certain is that the divergence between the yield curve and implied volatility will dissolve. Markets may appear confounded by cognitive dissonance, but forward-looking investors can peer through the fog: A return to a more recognizable risk/return profile, even if market returns are lower overall (as may well be the case over the secular horizon), could help investors more confidently align longer-term objectives with strategies.
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Flight 93 did it; Obola can do it!
Obola! You no say daddy me bama gonna blame
a licky boom boom down
transatlantic flights wont be stopped, that's rayciss, man
a licky boom boom down...
these guys are so smart ... they do deserve the big bucks they make ... not that lousy couple of hunderd the federalies make at NY Fed .. well, i guess they have the hope to make it someday at Goldmans iof the world
Wow! Obscure much?
Snow, out.
But can he do it without leaving marks on the grass?
would that be skid or Groucho (marks)......?
The trick isn't in "landing it". It's in "landing it safely".
Pieces of paper propping up other pieces of paper, I expect a final landing approximating the Hindeberg's final landing.
Oh the humanity.
Captain Yellen: 'Kay boys, we only get one shot at this!
Imagine there was a website that started every pundit w a billion imaginary dollars every Jan 1 (after all, a million ain't what it used to be). Then with every call, the account had to transact a trade to match, and the trade had be half of what ever dollar amount was valued in the account.
I would subscribe to such a site.
Who cares? Did you see those gays trying to destroy the sanctity of marriage? And those abortionists.
Who has time to worry about the Fed when gay weddings and abortions are taking place? In Jesus' homeland, America, of all places.
The United States of America: Successfully divided and conquered. Your corporate overlords thank you.
it's easier to land a jumbo jet on a football field than it is to knock down 3 steel redundantly reinforced, core columned towers with 2 planes.
Just sayin'.
I believe I can fly...
I believe I can touch this guy...
"Presently, the financial markets are confronted with two conflicting pricing structures: a USD yield curve that anticipates a significant increase in interest rates over the medium term, and an options market that offers “rate insurance” at a historically low cost.
An investment conundrum …"
no conundrum ... USD pricing in DEFLATION courtesy of basket case mercantile economies exporting it to us
Ineed.
Cash, Bonds, Gold...
Japan's 5 year is yielding .13%, the 10 year is at .48%, and the 30 year is at 1.6%....... just sayin.
http://www.bloomberg.com/markets/rates-bonds/government-bonds/japan/
sounds like PIMCO got themselves another Dope
Very funny!
Looking back, maybe calling 98 a Goldilocks economy wasn't sucha good idea.
But, it was a Goldilocks economy,... until the bears came home and interrupted her nap!
The American people are Bugs Bunny, the Gremlin is the Fed, and the plane is the economy.
https://www.youtube.com/watch?feature=player_detailpage&v=jljAMQNbl4Y#t=300
An American, not US subject.
But then: https://www.youtube.com/watch?feature=player_detailpage&v=zIQJey-BZ4s#t=322
Huh? Actually I think I only understood every third word. But I feel smarter for having read that...
"I am with you always, even unto the end of the world" Matthew 28:20"
if there's anyone who can land a jumbo jet on a football field, it's the fed.
you know why? becaues they can just keep printing money, and they will!!!!!
I thought it was because they could pay a judge to change the offical length of a football field.
The problem is that at some point it will simply stop working and the game will end. At some point it will become apparent the economic efficiency of credit is beginning to collapse and the additional money poured into the system coupled with lower rates can no longer drive the economy forward. When this happens we are at the end game.
At some point the return on loaning money is simply not worth the risk! Why do you want to loan money if most likely you will never be repaid or repaid with something that is totally worthless? When this happens the only safe place to store wealth will be in "tangible assets" and the only lenders will be those who print the money that nobody wants.
The collapse of credit can pose major problems such as what we saw when many sellers were forced to demand payment up front before shipping goods in 2008. More on this subject below.
http://brucewilds.blogspot.com/2014/06/the-economic-efficiency-of-credit...
This article is another example of how ZH can teach or inform. For those of us that did'nt have this depth of knowledge in this field this is much appreciated.
Old pilot's adage:
A good landing is one you can walk away from.
A great landing is one where you can reuse the plane right away.
I've made both kinds, and one bad landing...
So, uh, which options do we buy?
You don't buy what you don't understand... Options are speculative and a damn good way to go broke OR go to the Ferrari dealer.
I think that we all should come to accept as fact that the "banksters" will have their way with us for generations to come. Waiting for this particular "Day of Reckoning" is not unlike waiting for the Biblical one: it ain't happening in our lifetime, nor our children's lifetime either. It may get a little rough at the edges and for short periods of time; but it isn't going to change. The "banksters" Led by the FED JPMprgan, Goldman in the USA and supported by PBOC, BOJ, ECB, BOE and a handful of major financial firms, are going to stick together on this.
The FED has unlimited ability to expand its "bakance sheet". It has arranged it so that the US Government can borrow money created by the FED at near zero interest rates, whose loans are subsequently bought back by the FED some months later.
The US military will be used to enforce compliance with the WTO -World Trade Organization- which is regulated and ruled by banksters who are completely embedded into this network. Nothing is going to cut this off, short of total war, which will forever be avoided -the Globalists believe- because no entity will launch such a war knowing that one of the consequences would be its own destruction.
The task before us is basically twofold:
1 - Avoid becoming "collateral damage", becoming food for the sharks, getting stepped on by the elephants, being cut off from the food supply,or just being left behind.
2 - Find our niche, learn to cope, try to skip a few places in line so that we can feel that we are getting ahead.
Of course, Zero Hedge is the type of site which attracts many of the malcontents. That is good, because it gives us an outlet to the alternative world" which is more erudite and informative than others, especially the MSM. But don't put much credence in claims that there is going to be a day of reckoning, because "it is never different this time". At worst a token few of the "wrongdoers" are going to pay the price so long over due. Above all, don't invest your money in any scheme that promises profits when the new world order comes crashing down.
I am not sure I understand, I should not buy PMs?
Eggplant, avocado, hemoglobin, and malibu chart colors = cognitive dissonance.
There is no investing in this Ponzi, just gambling - and the house always wins.
oblig
https://www.youtube.com/watch?v=Bumx4AerJUQ
A jumbo jet can land on a football field...it's called a crash!
FED policy has done following:
1. negligible genuine sustainable economic growth resulting from to lower interest rates to consumers & businesses for genuine sustainable economic activity (instead of financial engineering)
2. grossly inflated the prices of financial assets through HUGE carry trades, record high leverage & financial engineering (eg record high stock buy backs by corrporations using cheap debt), ie the MOTHER of all bubbles
3. destroyed the interest-earning power of earned-money savings from who-knows-how-many-trillion dollars of created-money
4 greatly increased the inflation in agricultural commodities, ie FOOD, the ultimate essential
5. greatly suppressed the volume of lending from banks & non-banks due to absurdly low lending profits from record-low net-interest margins
6. provided White House & Congress with MEGA green-light to spend & issue trillions more debt with reckless abandon due to twilight-zone low treasury rates
7. increased my net worth by 50% in 6 years by exploding the market value of my financial assets - I already sold everything to keep the gains and am waiting in cash for the inevitable bubble burst
Plus many, many, many other negative effects, eg draining off securities needed as collateral in free market.
FED is an EXCELLENT example of a "domestic enemy".
To be fair, JAARS does this every day, all day long. I fly out of a small private airport near their practice fields in South Carolina, and they can drop a huge cargo plane full of supplies down on an unbelievably small patch of grass.
I'm not saying the FOMC is as skilled as JAARS pilots, but the analogy is not as strong as it may seem.
Well written and very informative. Thank you ZH
i think this is why they are planning to let inflation way overshoot.First, the Feds don't have the tax base in order to fund an increasing deficit if interest rates rise.It seems to time with what James Rickards says and gold will once again play a role and need to be repriced higher as well.It'll be interesting to see what happens during the bank holiday and what new plan the IMF and world powers bring to the world.I see a basket of currencies with the Americans kicking and screaming all the way down the road.