After building out Merrill’s mortgage trading floor basically from scratch, then moving to the buyside at Pimco, one year ago Harley Bassman, more familiar to Wall Street traders as the “Convexity Maven” – a legend in the realm of derivatives (he helped design the MOVE Index, better known as the VIX for government bonds) – decided to retire (roughly one year after his shocking suggestion that the Fed should devalue the dollar by buying gold).
But that did not mean he would stop writing, and just a few days after exiting the front door at 650 Newport Center Drive in Newport Beach for the last time, Bassman started writing analyst reports as a “free man“, in which the topics were, not surprisingly, rates, derivatives, cross asset interplay and, of course, convexity.
And, in his latest note, Bassman takes on a topic that has become especially dear to the Fed and most market observers: the continued flattening of the yield curve, the timing of the next recession, and what everyone is looking but fails to see, or – as he puts it – what is truly different this time.
Bassman’s full thoughts below:
The Path Forward
Let me offer a follow-up comment related to “Catch A Wave” from June 29, 2018. The Yield Curve, as described as the difference between the T2yr vs T10yr rates, will not invert until near the December FOMC meeting. This is when to start the clock for the typical 18-month lead-time to a recession (sometime in mid-2020).
As such, I am not bearish on SPX; the front-loaded corporate tax cuts will provide near-term support for earnings while the debt balloon is deferred to the Millennials (who to their chagrin, forgot vote).
The most common push-back questions why not just execute the steepener (long 2s vs short 10s) in spot (or forward) space: Positive carry and no option cost. The other frequent comment asks: Why now? If the curve will not invert until December, one should just wait until then for a better entry level.
My answer is “yes” on both counts, those are much better executions if you have certainty; but I am not so confident.
While we are now quite familiar with Trump’s negotiating style of ‘bluster and retreat’, it is quite possible that foreign leaders may actually take him seriously. Thus, similar to how WW1 was the unintended conflict, a global trade war could be the unfortunate result of clashing egos which will accelerate the risk calendar.
As such, I am willing to pay a few pennies to effectively own a three-year option two years forward via the purchase of a full term five-year option. Additionally, using options (instead of futures or swaps) offers a limited-loss risk profile with more leverage and the comfort of not being stopped out.
Others have commented that “it’s different this time”; that QE and unique FED policies will negate the inverted Yield Curve signal for a recession. Indeed it is different this time: Historically the Curve has inverted from the FED jamming their policy rate higher; in contrast, this next inversion seems to be driven by the back-end coming down.
Asset prices are a signal, such a pity that sometimes this information cannot be discerned until after the fact.
What is truly different this time is that past inversions have rotated around a ~5%-rate while this time we will rotate around a ~3%-rate.
The signal that an iceberg is ahead is NOT that the FED is jamming the Yield Curve flatter, but rather that long-term interest rates have declined by 30bps through the most recent FED hike; and that this is occurring despite massively expanding supply thanks to Quantitative Tightening (QT) and the Tax Package.
Market pundits like to say: “They don’t ring a bell at the top”. My retort is that they do, you are just not listening.
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Recent transactions I have done:
- Buy five-year expiry Yield Curve options, versus Sell three-year put (payer) option on 20yr rate – K = 4.0%
- Sell Closed-end Funds invested in High Yield and Loan Buy Closed-end Funds invested in MBS and MLP
- Buy MXN currency funded by short EUR (MXN/EUR)
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Author: Tyler Durden