From Harley Bassman, the Convexity Maven, May 2:
Jerome Powell, the Chair of the Federal Reserve Bank (FED), first discussed the concept of “transitory” in his June 22, 2021, testimony to a Congressional Oversight panel. Here, he was responding to the recently reported 5.0% year-over-year increase in Consumer Price Inflation (CPI).
Powell noted “recent price gains mostly reflected temporary supply bottlenecks” and that “they don’t speak to a broadly tight economy – the kind of thing that has led to high inflation over time”.
That same day, FED policy committee Vice Chair John Williams echoed that high inflation is likely transitory and that “I expect...inflation will come down from around 3% this year [2021] to close to 2% next year [2022] and in 2023.”
I dubbed pundits who aligned themselves with this notion as “Team Transitory”; and while their logic has some merit, their timing has been awful. The good news, as I will soon detail, is that the near record Yield Curve inversion combined with an elevated level of Implied Volatility finally offers some rather dreamy investment opportunities.
Looking forward and back
CPI is reported once a month as both a -arancia line- single month’s (MOM) change, as well as a -verde line- year-over-year (YOY) number.
The most recent one-month CPI (March reported in April) clocked in at 0.1%, so using bonehead math (ignoring rounding, compounding, seasonality, etc.) we could say this implies a one-year CPI of 1.2%. [0.1% times 12]***charts omitted***This is silly, so the Government also offers the annual (YOY) CPI change, which was reported as 5.0%. While the annual number is theoretically more robust, it too has limitations, given it is backward looking and can be greatly biased by “base effects”.
COVID-related declines of 0.4% and 0.8% in March/April 2020 contributed to the YOY CPI change from 2.3% to 0.1%. While those monthly dips quickly reversed, they remained in the YOY calculations until April 2021. Once removed, YOY CPI gapped to 5.0% from 2.6% which contributed to a bit of an Inflation panic.
This is how the FED and Team Transitory became entangled in their own shoelaces. They believed the Summer 2021 inflation spike was “base effects” driven and would soon reverse.
For myriad reasons, mostly political, the FED declined to curtail their COVID-linked “helicopter drop” of money until May 2022; and what some might call an uncontrolled ricochet, increased their Federal Funds rate at the fastest pace since Volcker in 1980.
Deferring the “why” and “how” for later, the FED’s actions have contributed to the most inverted -rosa line- Yield Curve since September 1981 where the two-year US Treasury presently yields nearly 50bps more than the ten-year UST (and 85bps in Libor rates).
FED actions have also had the undesirable consequence (from the FED’s point of view) of dramatically increasing interest rate uncertainty and -oceano line- Implied Volatility, as measured by the MOVE Index, to levels only rarely visited....
....MUCH MORE (11 page PDF)
Mr. Bassman knows some stuff. Among other things, he invented the MOVE Index, analogous to the VIX but for bonds. He's probably as knowledgeable about the interplay of inflation, interest rates and bond prices as anyone. Here's what we usually say at the top of the link:
First, our boilerplate introduction to Mr. Bassman:
...Wall Street loves to make convexity sound complex (I suppose it’s so they can charge higher fees?). We speak Greek (calling it “gamma”), employ physics as a metaphor (analogizing to it “acceleration”), and use mathematical definitions (since it is the second derivative of the asset’s price change)."Pish. Posh." is a technical term only used by market professionals for those situations where one has decided to go full Alinsky rule #5:
Pish, posh. An investment is convex if the payoff is unbalanced for equally opposite outcomes. So if there’s the potential to earn a profit of two on a bet versus a maximum loss of one, the bet is positively convex. If you can lose three versus making two, it is negatively convex. That’s it. The rocket scientists are called upon to help (fairly) price the cost (value) of such possible outcomes. This is why the expansion of derivative trading in the 1990’s resulted in a hiring spree of physics PhD’s....
#5 Ridicule is man’s most potent weapon. It’s hard to counterattack ridicule, and it infuriates the opposition, which then reacts to your advantage...The Convexity Maven is nothing if not a professional. Here is part of his mini-bio at MacroVoices:
Harley S. Bassman
Harley Bassman created, marketed and traded a wide variety of derivative and structured products during his twenty-six-year career at Merrill Lynch. In 1985 he created the OPOSSMS mortgage options product that facilitated risk transmission between MBS originators and financial institutions. In 1988, he assumed responsibility for trading and marketing IO/PO and other levered prepayment securities. Soon after this, he started purchasing RTC auctioned MBS Servicing rights and repackaged them for the securities market as BIGS - Beneficial Interests in GNMA Servicing. Later, he started a GNMA servicing conduit becoming one of the Top 20 originators in 1992. As managing and hedging prepayment risk became a priority focus for the financial markets, Mr. Bassman created PRESERV, Merrill's trademarked Prepayment Cap product. Merrill was a leader in this product category writing protection that covered the risk on tens of billions of notional mortgage servicing rights. Later, Mr. Bassman managed Merrill's initial venture into off-balance sheet mortgage trading.
In 1994, Mr. Bassman assumed responsibility for OTC bond options.
Within a year, Merrill was the leader in this product sector. A wide variety of products were offered including vanilla and complex options on MBS spreads and the Treasury yield curve.
To help clients more fully appreciate Volatility as a primary risk vector, he created the MOVE Index. Similar in form to the VIX Index, it is now the recognized standard measure of Interest Rate Volatility.
From 1995 to 2000 he focused on creating hedge strategies for MBS servicers and portfolio optimization techniques for Total Return and Index investors.
Mr. Bassman became the manager of North American MBS and Structured Finance trading in 2001. During his tenure, he created SURF, (Specialty Underwriting and Residential Finance), a self-contained Sub-Prime mortgage conduit. He supervised the issuance of Merrill’s first Sub-Prime securities. He also transitioned the structuring business to a new technology platform.
In 2006 he built the RateLab, a full spectrum US Rates Trading Desk Strategy Group. Here he worked with investors to advise and optimize their risk exposure. As a key member of the client trading business, he facilitated activity by providing liquidity to both the firm’s clients and market makers.
After a (too) brief sabbatical, in 2011 Mr. Bassman joined Credit Suisse's Global Rates business where he identified and integrated investment and hedging opportunities for sophisticated investors.
Most recently, Mr. Bassman was an Executive Vice President and Portfolio Manager at PIMCO - a leading global investment management firm. Here he managed investments for the Liquid Alternative products group as well as advised on portfolio strategy across asset classes for the firm's franchise businesses.
Mr. Bassman splits his time between Laguna Beach, California and New York City. He has a B.A. in management science from the University of California, San Diego and an MBA in finance and marketing from the University of Chicago....
