Bonds: There is a Vortex Risk in Front of Us

By May 26, 2013, 8:29 AM Author's Blog  

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, 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.

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