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Saturday, May 25, 2013

Bond Vortex In The Works?

 

I got an email from a friend who runs money for a hedge fund that got my interest:

 

may want to take a look at convexity vortex in mbs market and implications…

 

“Convexity vortex’? What’s that about? A bit more from this fellow, I’ll call him ‘MP’:

 

Some familiar with it say the vortex is 19 bps away..2.2% on ten year treasury, 3% on the CMM..if breaks, MBS holders subject to extension and duration risk.  Would now have to increase convexity hedging.  Would lead to price gaps and significant selling.  With shortage of treasuries due to bernank and co. and low liquidity, could be very disruptive.

 

That got me interested. A layman’s explanation of convexity:

When mortgage interest rates fall, the probability that an individual will re-finance a mortgage increases. When mortgage interest rates increase, the likelihood of a re-financing of the mortgage goes down. Therefore, in a rising rate environment, the average life of a pool of mortgages increases. For example, if a bond fund held Mortgage Backed Securities (MBS) with an assumed 10-year average life, AND interest rates rose, the average life of the MBS portfolio would be extended for a few years. This is convexity. The last thing that a bond manager wants in a rising rate environment is to have the average maturity of the portfolio extended, as this adds to the losses. As a result, MBS players hedge their portfolios against “duration risk” by shorting Treasuries (ten-year paper). The higher rates go (and the speed that rates are increasing) forces more and more of the convexity selling.

 

MP believes that there is a magic number of around 2.2% on the ten-year bond that will bring out an avalanche of convexity selling. The 2.2% tipping point is very close to where the T-bond sits today.

The fellow who brought this to my attention is a perm-bear on bonds. Given that, I sought out a confirmation from another guy (call him JH) who has been bullish on bonds for many years. JH sits on the bond desk of a big international bank. When I posed the question to the Bond Bull I got a surprising response:

 

I don’t disagree – I would guess we have a huge concentration of mortgages that would go out of the money at 2.25% 10yr UST, slowing prepays, extending servicer portfolios, bringing on longer duration UST selling ……

 

So there is a vortex risk in front of us. The weaker the ten-year gets (higher yield), the more selling is required. Is the Vortex going to happen? That depends on the performance of the bond market, AND on how the dealer community is positioning themselves against what is a clear Event Risk. The bond bull, JH, had this to say about the probability of a vortex being reached:

 

in the absence of a real, organic, self-sustaining recovery, I think this all self-corrects – in the medium term anyway, IF it actually gets to that 2.20% range we could see convexity selling..  but in this environment those higher rates won’t sustain..  in fact, I don’t think they even get to 2.20%, but if they do, and convexity selling ensues, and it’s exacerbated by a ‘thin float’ due to the Fed’s presence, it’s temporary and I’d argue a massive buying opportunity

 

JH does recognize that there are risks:

generally speaking, and in regards to ‘taper’ of QE, soon as the Fed pulls back, we will see a spike/knee-jerk higher in rates (which I argue we are seeing in ‘anticipation’ of this happening; imo misguided)

 

Bernanke has recently said that the Fed is in the process of  changing the monthly QE purchases. He has said that the amounts of POMO (QE) that is completed on a monthly basis will vary based on “incoming information”. From this I conclude that the Fed will, in the coming months, announce a taper of its purchases. When this happens, it’s likely that the bond market will “spike/knee-jerk” higher in yield – and when that happens the convexity selling will bring even higher yields.

The Fed isn’t going to like that result. They do not want to lose control of the long end of the yield curve. So, if and when the convexity selling hits post a QE Taper, the Fed might respond by increasing the next month’s QE in an attempt to drive long rates back down. Bernanke has basically promised to do just that.

What happens if we get this scenario?

1) The Fed cuts the monthly QE from $85Bn to $50Bn,

2) The bond market craps out and 2.2% ten-year is reached.

3) Convexity selling occurs and drives the bond market down another notch to a 2.5% yield.

4) The Fed responds to the disarray in the bond market and announces that in the next month QE will be increased to $150Bn.

 

This is a realistic outcome. It could happen in the next 90-days. There are two ways that a situation like this plays out. JH, the bull, could be proven right in that bonds purchased with a 2.5% handle will be a good investment. The bond bear, MP, had this to say about the Fed ramping up monthly QE in response to a market correction in yields:

 

if Fed has to increase buying to stabilize, I would argue it is a very negative development for all markets.

 

I’m not smart enough to figure how this one plays out. It has a great deal to do with two unknowns – how dealers are positioned, and how the news flow from the Fed progresses over the next month or two. The fact that two guys who trade bonds for a living are well aware of the ‘vortex risk’ as rates approach 2.2% tells me that all of the bond guys are watching this. So, to some extent, the news is already in ‘today’s print’ for bond yields. The opposite could also be the result. When a market understands that there will be forced selling at a certain level, the market always tries to push to the level where the stop-loss selling has to occur. To me, this suggests that the bond market is going to try to test the 2.2% rate.

I do agree with MP; if the bond market gets soft, the Fed will respond with a very large dose of monthly QE. And I further agree that if it plays out like this - it will prove to be a very negative development for all markets.  The inescapable conclusion from this scenario is that QE is FOREVER. Taper talk will prove to be just talk. When players come to understand that the only leg the markets are standing on is endless/massive QE, there will be a shudder of fear.

 

What’s the probability of this playing out as described? I would normally say that the ‘worst case’ will not happen. But there is something else going on in bond land that is running parallel to the Taper/convexity selling that the US is facing. Japan is looking at a very similar outcome (for much different reasons). As Kyle Bass pointed out last week (Zero Hedge LINK), the promise of 2% inflation and 1% bond yields doesn’t have a happy ending. In an effort to cap Japanese bond yields, the Bank of Japan will respond with ever higher amounts of QE. The BOJ has to do this – the entire Abenomics goes up in smoke if the Japanese bond markets puke.

 

There are forces developing over the next few months that may push the BOJ and the Fed to take some extraordinary actions. That these two big CBs are facing the same potential outcome, at the same time, is troubling for me. I see this evolving story as a possible turning point. The key CB’s will have gone from Offense to Defense.

For five-years the CBs have enjoyed being on the offense. They have successfully controlled things so far. But I can’t imagine how they can continue to be “successful” when they are forced to defend (versus lead) the bond markets. 

 

knom-vortex

 

 

 

 

 

Comments

  1. When measuring “thin float” in US treasuries, don’t forget all the treasuries needed to collateralize repos and derivative positions.

    • when bond yields get high enough people will get out of equities and back into bonds thus limiting the rise of bond yields.

  2. 30 bps qualifies as a vortex now?

    • 30bp is a 15% change in rates. If 2.5% is reached, that would be a 25% correction. So yes, that would be a vortex.

      • Assuming a duration of 9 on the 10yr bond, a 30bps yield increase equates to a 2.70% decline in bond prices. It’s really not that dramatic. Take a look at the total return of the 10yr on a 12 month rolling basis since ’32, the biggest decline was 12%. Bonds just don’t have an extreme left tail historically and that sample covers a number of different environments.

  3. Calvin Harris says:

    Is there such a thing as justice anymore?
    Should we be hoping the cb’s can pull off monumentally stupid and arrogant policies without it coming back and biting them in the butt?

  4. ” The inescapable conclusion from this scenario is that QE is FOREVER”

    Thats when gold blasts off

  5. Obama bin Biden says:

    The always dreadful… CONVEXITY VORTEX !!

    I was hoping it wouldn’t come to this, but here we are, at convexity!

    HFT algorithms couldn’t do it, neither could massive manipulation of LIBOR, dark pools seem like child’s play and flash crashes don’t scare anyone anymore. But a convexity vortex? We’re in for some strange sailing in these waters.

  6. Fear Mongerer says:

    There is no exit strategy and you know it BK. Ben’s stuck with ZIRP/QE and he’s not going to let the 10 year get up to 2.5! If anything he’ll put pedal to the metal and bring it down to 1.5. Now that would be a story worth writing about.

  7. Zorba The Greek says:

    What’s really scary is that most people think the Fed has everything under control,
    but they didn’t even see the housing bubble when it was staring them in the face.
    The people in control of the world are so under qualified for the job, it makes me shutter
    to think how they will react to a real crisis.

    • Fear Mongerer says:

      under control is not the same as in control. The central banks of the world are in control, but I agree that things certainly aren’t under control. QE infinity until the tipping point is reached and then it’s time for gold and guns.

    • The truly qualified for this job understand the inevitability of unintended consequences, in opposition of the intended affect. It is the height of arrogance to believe otherwise. for example, is it obvious to you that encouraging bank runs is the way to strengthen the banking sector?

  8. Leftover Tuna Sandwich says:

    It would appear that Denninger has picked up on this story. I can’t say as I fully understand this 2.2% convex stuff, but it certainly sounds the same.

  9. is this why the REITs are going trending downward since the interest rates are rising??

  10. We have been confounded this far. What has happened in markets has surprised many. But in the short term anything can work. People often talk of things such as the “decline of the Roman Empire” etc but those took decades.

    Over a few years, anything is possible. Over decades, what should happen likely will – we just don’t often live long enough to see it. a 30bps move in the long bond (not 10 yr) would be rather large. If anyone is still using a discount model to value stocks (anyone left who hasn’t moved exclusively to charting? – nothing wrong with it but def a “trend”) then 30bps is a large percentage move in the long bond.

    I have no idea how this plays out – it will simply be fun to watch central bankers act like they still have control when they seem not to have it at the edges. And no doubt- if things don’t go the way central bankers “want” they will print all the way down (think Vader tossing the emperor over the side while those shock bolts are still firing from his hands).

    Prob a good time to own options in every direction on everything – price is cheap and moves in the near future may be huge though direction isn’t known yet (easier done for a guy like Bass who can create his own).

  11. “When players come to understand that the only leg the markets are standing on is endless/massive QE, there will be a shudder of fear.”

    It seems to me we’re already caught at the event horizon, but nobody wants to accept it.

    • bill mccollough says:

      Well, if we are caught in a event horizon perhaps we will find out what happens at a singularity.
      This has baffled physicist for decades. We get to divide zero into CB infinite QE.

  12. Bruce,

    QE has been “forever” for quite some time. The monetary authorities can no more allow the lack of demand to manifest by ceasing to soak up the lion’s share of new bond issuance than they can allow everyone to opt out of their income tax. Without The Fed and its PDs picking up the slack rates would rise to levels that would quickly send things into the monetary equivalent of Def Con 1. Do you really see it differently?

    It seems to me that “convexity” simply amounts to delivery of the message up close and personal via loudspeaker. A QE exit will happen under one condition, and it will mean the end, lock, stock and smoking barrel of the present dollar dominated IMFS (International Monetary and Financial System).

  13. Interesting post.
    I thought I understood convexity of the price-yield curve and duration but I do not really understand the following:

    “Therefore, in a rising rate environment, the average life of a pool of mortgages increases. For example, if a bond fund held Mortgage Backed Securities (MBS) with an assumed 10-year average life, AND interest rates rose, the average life of the MBS portfolio would be extended for a few years. This is convexity. ”

    Normally the price-yield curve will increase as yield decreases, and vice versa. Therefore, as market yields decrease, the duration increases. The above states the opposite, right? if so, why? Or should I not confuse “average life” with “duration”.
    Why is that “convexity”? the the price-yield curve ios convex, where is the convexity you discribe here?

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