[Editor’s note: The following is from the latest commentary by Harley Bassman. If you’re not familiar with Bassman, he (literally) created the MOVE – more here.]
Excerpted from “I Picked the Wrong Week…”, by Harley Bassman
Barring an Act of God, it sure seems like the Yield Curve will notch up another win by predicting a recession to occur about eighteen months after its inversion. I suppose some may assign a ‘Roger Maris’ style asterisk since it was shoved by the spread of COVID-19 rather than a Federal Reserve induced tightening of financial conditions; but let me assure you that a decade from now analysts will only note a –achromatopsia– recession bar after the –nebula line– Curve flip.
It was well known that market risk often follows an inversion of the Yield Curve, and I joined the cacophony in “Catch a Wave…” – June 27, 2018.
But the more troubling concern was how the migration of assets from “Active” managers to “Passive” Index funds created a negatively convex profile that could effectively replicate the Portfolio Insurance dynamic in 1987, as outlined in “Rambling near the Edge” – July 10, 2017.
To be fair, ignoring this warning has proven a fine idea since the S&P 500 closed at 2427 on that publication date. So, if you included the roughly $149 of dividends paid over this 33-month period, your breakeven would be about 2248 – so you would still be above water.
Nonetheless, one should expect significant volatility to continue for a while. This will be in stark contrast to the past few years where every spike in the VIX was met with option sellers who quickly quashed it.
To offer a sense of scale, the –pulsar line– MOVE Index closed at 141 last week, after touching 188 on an inter-day basis the week prior. This level has only been exceeded by the aftermath of the Lehman collapse.
While I cannot predict the path of Equity prices or its volatility, I can comfortably prognosticate on interest rate volatility, specifically the MOVE, which should soon decline.
Notwithstanding that the professionals who sell interest rate volatility for a living have mostly been carted off on a stretcher (and not from COVID-19), there are two factors that should soon blow out the flame that has elevated the MOVE.
First, please recall that the shape of the Yield Curve is a primary driver of rate volatility. Detailed in “Your Ace in the Hole” – July 16, 2014, the –corot 7b line – slope of the Yield Curve should be considered a risk metric for uncertainty in the moderate future; and since the –planemo line– of Implied Volatility is functionally the “price of risk”, the two should travel hand-in-hand.
The FED has finally wheeled out the howitzer(s), and effectively re-tweeted ECB chief Mario Draghi’s famous 2012 speech to do “whatever it takes”.
Unless you believe in negative rates, which I do not, the Yield Curve has a floor of zero, and a ceiling of some number that is not too much above current levels. As such, a roughly 40bp distance between the Sw2yr and the Sw10yr could easily slice the MOVE by a third. As a matter of fact, it has the potential to drop by a lot more since the USD rate structure is now quite similar to that of EUR and JPY, which have historically traded with about a 20% discount.
It is grossly inappropriate for senior political leaders to speak of “hunches”. In times of stress and uncertainty, I want Sgt. Joe Friday: “Just the facts; Ma’am”
I would like to say I saw this coming, but I cannot. I have appreciated the negatively convex profile of the market, and was astounded by the low levels of Implied Volatility. This is why my most favored investments have involved buying options with five to ten-year expiries, and thus a huge Vega-kicker.
COVID-19 is worse than the flu, and there is not enough data to opine further. Some evidence suggests there is a seasonal (32F to 52F) component, and as noted by Torsten Slok’s chart, it can be contained with enough social will power.
I urge you to watch any YouTube clip of Governor Andrew Cuomo of New York to see real leadership in action. If state level initiatives are supported by the full weight of the US Government, a suggested 45-day timeline to “bend the curve” seems possible. This dovetails with the average low temperature in New York exceeding 50 degrees by late April, and a bit earlier in Laguna Beach.
The key point is that both society and the markets do not require a cure to stop the panic, just the knowledge that it is not a black hole of uncertainty. It is well known that 30 million people catch the season flu annually, with an associated mortality of 40,000. This does not cause a blink because it’s a known risk; the problem with COVID-19 is that it is presently an unknown risk. I suspect that Volatility calms once we know the boundaries, which might be well before a cure.
Assuming the above, and QE~ + MMT come as offered, in late summer I expect Pension Funds to sell 1% yielding bonds to buy a 3.0% yielding Dow.
But be careful, the next six weeks of uncertainty will likely prompt the S&P 500 to “check the oil” at the 2016 election day level of 2139; a truly ironic coda.
Harley S. Bassman March 23, 2020