The Fed’s ‘Short Volatility Position’: A Closer Look At Jerome Powell’s Comment

On Friday, transcripts from the Fed’s 2012 meetings were released, giving investors a chance to get a read on what incoming Fed Chairman Jerome Powell thought about the evolution of the central bank’s extraordinary measures taken in the aftermath of the crisis and designed to shore up the economy and, perhaps more to the point, inflate financial asset prices.

One of the quotes that’s been making the rounds comes from the transcript of the October 23-24, 2012 meeting which found Powell expressing what might very fairly be described as serious reservations about the extent to which the Fed was encouraging risk taking. There are a number of punchlines from Powell’s comments, but we wanted to zoom in on this quote:

Take selling–we are talking about selling all of these mortgage-backed securities. Right now, we are buying the market, effectively, and private capital will begin to leave that activity and find something else to do. So when it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position.

Ok, so a couple of people have written in asking if that’s Powell somehow conceding that the Fed is literally shorting the VIX.

To be clear, the short (get it?) answer there is: “no.” As explicitly stated in the excerpted passage above, Powell is talking about the MBS portfolio. He’s talking about negative convexity. He’s talking about what happens when the Fed stops effectively absorbing prepayment risk and thereby dampening rates vol. by obviating the need for MBS investors to hedge.

As one derivatives strategist we spoke to on Saturday put it, “because they keep holding MBS, they are assuming some of the short vol. position on an ongoing basis.”

That’s not to say that the Fed’s communication strategy vis-a-vis markets hasn’t served to tamp down equity market vol. It obviously has (more below). But as to whether the specific comment above from Powell had anything at all to do with the VIX, the same derivatives strategist quoted above said simply this: “That’s completely wrong.”

A second derivatives strategist who spoke to us on Saturday described the idea that Powell was referring to the VIX as “confused” while a third source (a trader), had this say: “that [comment from Powell] has nothing to do with the VIX.”

Where there is some disagreement, however, is on whether the MBS runoff will have a substantial impact on rates volatility. It’s easy to posit that volatility will rise as the Fed unwinds, but as the second strategist mentioned above notes, that depends on hedging behavior. To wit:

For this convexity to be transmitted to capital markets, you have to have active hedgers, like servicers or GSE. This is how it was before 2005-6, when all of them had consolidated hedging practices. It was really the carry game for them: whenever MBS provided excess carry, they could spend some of that carry to buy.

These guys have disappeared largely after GSE conservatorship. Bank MBS portfolios grew on the back of real estate boom while volatilities declined to all time lows (still uncontested). There was a record amount of MBS negative convexity in the market, but nobody got excited. Why? Because nobody was hedging it and so that convexity was not transmitted to markets.

Nowadays, the situation is even more extreme. People are seeing carry in everything and they jump from one asset to another depending on which one gives more carry (short vol, MBS, credit, etc.). No one is hedging convexity anymore. Typically, they manage MBS in a portfolio context. So, releasing them into the market will be a duration event, but not convexity per se. Any cheapening on top of Treasuries is likely to entice buyers.

In principle then, if they run down the MBS portfolio and there’s some yield to be had on top of what you’d get in Treasurys, the yield chasers will come in and unless they hedge, the effect on rates vol. would likely be minimal.

Again, in principle. As the first strategist mentioned above notes, “[that assumes] the market will buy it and not hedge.”

Seemingly, there would have to be a systematic program of convexity hedging across the industry and according to the strategist quoted at length above, that was “dismantled more than a decade ago.”

Getting back to the point about the VIX and, by extension, about the Fed’s effect on equities, the story there is the same as it’s ever been. The two-way communication  loop between policymakers and markets which effectively allows the market to have a “say” in the evolution of the policy narrative clearly dampens vol. across the board. So in that sense, there’s some merit to the point about equity volatility.

The bottom line, according to all three of the sources quoted above, is that what Powell said in 2012 is largely irrelevant now.

“He now has a concrete problem to deal with and his private opinion has to be put in the context of managing the risk of the Fed’s exit,” one of the sources said.

“That was 2012 – ages ago,” another chimed in, before posing the following question: “who cares what Powell said back then?”