Bassman: Here’s What’s Happening With The Curve

Bassman: Here’s What’s Happening With The Curve

Indeed the Fed has been slow in shutting down the money printing; and the market is anticipating a quickening of policy that may well lead to a recession sometime in the summer of 2023, but that does not explain the extreme volatility in the bond market, usually a bastion of safety.

A Commentary by Harley Bassman

This is a quick off-cycle comment to explain what is happening to the yield curve.

Indeed the Fed has been slow in shutting down the money printing; and the market is anticipating a quickening of policy that may well lead to a recession sometime in the summer of 2023, but that does not explain the extreme volatility in the bond market, usually a bastion of safety.

Over the years, Wall Street devised structured notes to offer civilian investors a way to earn an above market yield, without any credit risk.

These notes, issued by the Too Big To Fail banks, might offer an 8% yield for a year and then pay five times the spread between the two-year rate and the 30-year rate. So if that spread was 150bps, a level it was at just last year, the note would kick off a coupon of 7.50%. (Well above the junk bond yield of ~5%.)

This structured note would also have a “zero-strike floor,” so if this spread ever went negative, the client would not owe Wall Street any money.

Wall Street dealers would hedge this risk via various means, but this included being short this “zero-strike option,” which I will tell you is tremendously hard to manage.

When the 2s vs 30s spread approached zero, Wall Street dealers went into panic mode as they were short convexity on the curve via this option. To hedge this risk, they quickly started selling two-year bonds and buying 30-year bonds. And as you know, each time they did this, the negative convexity made it worse.

BBG

Above is the actual volatility of the 2s vs 30s yield curve spread.

A similar occurrence happened in 2008, which I detailed here.

What is important to note is that unless these structured notes mature (or are called), this option is still in the market.


 

4 thoughts on “Bassman: Here’s What’s Happening With The Curve

  1. The key words here are safety and credit risk and the relationship to secured versus unsecured financial instruments.

    In my humble and worthless opinion, the Bermuda Triangle chart I posted on a prior earlier thread is a way to look at what may be happening.

    As market volatility and risk increase, people prefer secured positions over unsecured and that sets up a condition that reduces liquidity. Theoretically, I assume that increases price and lowers yields, but like poem says, water, water everywhere and not a drop to drink.

    I also think the short term bond gears are clogged up with fed interference which is adding to volatility due to massive swaps supply, which is additionally constrained between trading caps and their statutory rules on fails settlements.

    Additionally, this gumming up sand in the gears situation adds to banks hoarding short term treasury positions adding to liquidity dysfunction dynamics, which one assumes will greatly increase as rates are hiked.

    And, related to raising rates, that looks like a massive overreaction, in terms of tearing down the house to replace the toilet. The Fed Troop is looking through a straw to locate the universe. Maybe they can’t win in this post pandemic world and maybe their models aren’t robust enough to adjust to just in time on the fly economic volatility, but, it looks like that transitory inflation thing just might be kicking in.

    If the Fed hikes too much, too fast, they’ll seriously kill off an organic recovery and fuel generational inflation. Parts of the bottleneck shipping problem are resolving and the backlog of inventory might be deflationary.

    From some random shipping thing:

    “Following inflationary trends hitting consumers, such as rising prices of retail goods and soaring mortgage rates, freight demand is slowing down toward a grim outlook for the second quarter of 2022. The Outbound Tender Volume Index (OTVI) posted levels slightly below those of last week and remains far below year-ago levels.

  2. I think one of the reasons this is making less and less sense, is because fewer and fewer people understand the language being used by the Fed Troop and people like Zoltan. It’s very nice to have Bassman insight to add to this lexicon. Nonetheless, this Tower of Babel is overwhelming.

    For anyone short on Fed repo structure, this is pretty good:

    “September 2021, No. 21-31
    The Fed’s Evolving Involvement in the Repo Markets
    By Huberto M. Ennis and Jeff Huther

    “With the ON RRP, the Fed could become the preferred borrower for many investors during periods of financial stress, abruptly depriving regular repo market participants of funding when that funding may be particularly important. Such flows could be exacerbated by lenders’ knowledge that their usual counterparties can turn to the SRF for funding. That is, the Fed could be both the favored borrower and favored lender when financial uncertainty is high. These concerns were raised initially at the time of the ON RRP creation and continue to be an important consideration.9”

    9

    The extent of spillovers from the repo market into the fed funds market is hard to quantify…

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