From Harley Bassman, the Convexity Maven, September 16 i.e pre-FOMC:
The nattering nabobs of financial punditry are burning ink on whether the Federal Reserve Bank (the FED) will reduce their overnight Federal Funds rate by 25bp or 50bp….I don’t care.
The more relevant question is what happens over the next twelve months.
Most informed investors are aware of the massive disconnect between the various asset classes; but some may not appreciate the fireworks in the bond market since the celebration of July 4th a few months ago.Today’s commentary will be brief, and unlike most “two-handed” economists I will offer an opinion. But what is almost certain is that the financial markets will soon have that “Come to Jesus” moment of sudden realization, comprehension and recognition that often precipitates a major change.
What I repeat ad nauseum, and cannot stress enough, is that “Forward rates” are not the market’s prediction of the future. Rather, Forward rates are simply the mathematical break-even between two different maturity investments.
In a nutshell, if Grandma can buy a one-year CD at 3% or a two-year CD at 4%, she would only buy the one-year CD if she thought that in twelve months, she could buy another one-year CD at 5% or higher. We would call this 5% rate the one-year rate one year forward (or the break-even rate).
Waving off a few details, earning 3% for the first year and 5% for the second year is like earning 4% per year for the full two years. For any two dates one can solve for the “break-even” rate for the third leg such that one is indifferent.
When the Yield Curve is inverted, that math is a bit upside down, but computationally the same. If the one-year rate is 5% and the two-year rate is 4%, then the breakeven for the one-year rate next year will be 3%.
In this example, Grandma would only buy the two-year bond at 4% if she thought the one-year bond a year from now would be less than 3%. Such is the financial landscape presently where the US Treasury two-year rate has declined from 4.71% on July 3rd to a current rate of 3.58%. This has created a record -nila line- inversion between the current Fed Funds rate and the two-year rate; a spread usually associated with an economic train wreck.
While not a prediction of future, the break-even for such a constellation is rather astounding. I will save you the math and offer that the current UST one-year rate would need to decline from its current 3.97% to 2.97% by the end of next summer to make owning a UST two-year a profitable proposition....
....MUCH MORE
Harley knows stuff. 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....
And so much more, all those cutesy Merrill acronyms can be blamed on him and his team.
Many, many previous visits seem to imply I have gotten past the cutesy product names.
