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Bassman: Fed ‘Backed Into A Corner’
Long-term US rates at ~2.50% are not consistent with ~5% inflation unless the Fed invokes Yield Curve Control. More bothersome is that the SPX at 4575 (and VIX at 20) is not sustainable if an inflation-cooling recession harkens. An inverted Yield Curve never ends well, and option prices are way too low for a Fed backed into a corner while the Russians are testing their nukes.
Square Pegs
A Commentary by Harley Bassman
Cognitive dissonance is often defined as simultaneously holding conflicting
Thank you Mr. Bassman as always!
Didn’t he suggest buying mortgage financed spy leaps just a few months ago?
FYI from Liberty Street Economics. The Bassman stuff is excellent!
MARCH 24, 2014
Convexity Event Risks in a Rising Interest Rate Environment
Allan M. Malz, Ernst Schaumburg, Roman Shimonov, and Andreas Strzodka
“The low rate environment had arguably set the stage for a convexity event (historically low rates coupled with substantial negative convexity). As the ten-year yield rose from 1.70 percent in early May to 2.90 percent in August, mortgage portfolio durations extended significantly, forcing MBS hedgers to sell duration, or to sell the underlying MBS. However, by all accounts, the MBS-related hedging activity was more muted than in previous bond sell-off episodes, including those in 1994 and 2003.”
This analysis should throw water on the hot take that Biden is somehow responsible for the current inflationary event we are experiencing. We (as in the royal) are responsible for inflation by digitally printing money to the tune of a 466% increase in M2 supply over the past 22 years.
It’s obviously not easy to understand the Fed actions or hot to interpret their portfolio in terms of strategy or how their QT efforts will mix with roaring inflation. The convexity and duration extension risks from 2014 are entirely different and with all the Fed activity from the pandemic, especially buying massive MBS, I find it very hard to believe that their system will be able to manage this mess. The jawboning of raising rates in a parabolic spike simply seems ass-backward and a recipe for generational disaster.
I think the Fed is using a textbook from 1822 to fight a 2022 quantum mechanics problem.
TMPG meeting march 2021, long before inflation exploded:
? Actively hedging accounts (GSEs, mREITs, etc.) currently own only
~11% of the Agency MBS universe, making their hedging needs
relatively smaller than in past convexity episodes (e.g. 2003, 2013)
? Although there has been some delta-hedging, investors have
reportedly been better positioned, running relatively short
duration exposures entering 2021
? Current positioning of hedging accounts is difficult to estimate,
suggesting convexity hedging needs could increase if rate selloff
continues.
At current rate levels, mortgage servicing rights are likely to be the
most negatively convex, suggesting a further selloff will lead to
more hedging needs
Thanks H for bring Mr. Bassman to our attention and for our edification. Great insights and his way of presenting charts is top drawer.