Recorded at 5.30pm EST on Wednesday 11th November.
For Episode 103, we are joined by fixed income legend Harley Bassman, creator of the MOVE index and the man behind The Convexity Maven. Harley explains why this rate cycle is about fiscal malfeasance rather than inflation, why TIPS at 3% real are the wrong number, why re-IPOing Fannie and Freddie is a moral hazard disaster, and why things get “very jangly” if Treasury yields approach 6% again.
Show Notes
How to Read The MOVE (index)
Harley created the MOVE index (the “VIX for bonds”); first published in 1994, with internal data extending back to 1988/89
Historical MOVE range was 80 to 120; more recently 60 to 100, or 70 to 110
The MOVE is a real number, not a rebased index: a reading of 100 implies a one standard deviation (68%) chance rates are plus or minus 100bp a year from now
Divide by sixteen (technically by 15.9, the square root of 252 trading days) to get the daily implied move: a MOVE of 100 means roughly 6bp per day; a VIX of 16 implies a 1% daily S&P move
“All of vol trading is ninth grade statistics dressed up with Greek letters to justify higher fees”
Why convexity is hard (Minute 4)
Volatility confuses most participants because it is non-linear and path dependent; a bond that travels 100 to 110 to 90 and ends at 101 made one point, but an option’s outcome depends on how you get there
Humans think in two dimensions; convexity is a three dimensional problem, and most people are neither paid nor trained to think that way
Leveraged ETFs paying 2x or 3x the daily move are a massive short convexity position few holders realize: up 10% then down 10% leaves you at 99, and repeated round trips grind the asset toward zero
This year has been a live lesson in path dependency, with rates walked up and down repeatedly
What is really driving rates (Minute 7)
Harley argues the rate rise is not about inflation: ten year breakevens have sat near 2.35% for three years straight
The real driver is the fiscal situation: a roughly 6% deficit with 4.1% unemployment and solid GDP, which historically only happens in war or recession; a real recession could push the deficit toward 10%
The Treasury will borrow about two trillion dollars net this year; AI capex adds another 700 to 800 billion, meaning a handful of tech companies will borrow roughly a third of the federal deficit
That supply dynamic explains rising rates across the West, the US in particular
On Michael Green’s passive thesis: Harley is agnostic, noting active bond managers still beat the index, though he concedes supply one day equals demand
As a University of Chicago-trained monetarist, he holds the old rule that ten year yields should sit near nominal GDP: with nominal growth around 6%, a ten year at 5% is not crazy and 3% was the wrong number
He is a self-described inflationist: expects inflation near 3% for a long time, driven partly by millennial household formation, an echo (smaller in percentage terms) of the boomer “pig in the python”
Fiscal politics and the inflation exit (Minute 14)
On the three variable problem (rates, currency, fiscal): you can only control two; Japan controlled rates and the yen went from 80 to 160; the US faces the same arithmetic
MMT was theoretically right (borrow until inflation appears, then tighten) but politically impossible: politicians are paid to get reelected on two year cycles, not to cut spending or raise taxes
The silent default will be inflation, a stealth tax on the middle class; run nominal growth above the debt rate and debt to GDP burns down, as after World War II
The mean vs median economy (Minute 17)
Stocks are fine as long as unemployment stays below 5%, because millennial 401k money recycles into passive indices regardless of price
His advice to his own kids: “max the 401k, take the match, 70 to 80% in an S&P index fund, the rest in a five year IG fund, reinvest, call him in thirty years”
The post pandemic “jaws” between the S&P and consumer sentiment is simple mean versus median: in a village of ten where one person earns 500k and nine earn 10k, the average is 50k and the median is 10k; nationally the economy looks great, individually it feels terrible
The Fed cycle and rate levels (Minute 22)
The Fed will keep hiking as a reults of hubris; Powell and Kevin Warsh both want to be Volcker, not Burns, so they will keep tightening until inflation is resolved. Harley thinks the Fed has a couple more hikes in it.
His levels: hard to see two year notes above 5%; ten year fair value is 4.35%, but he has no problem with tens trading up through 5% before falling back
At some point a government guaranteed yield beats stocks at a giant PE; a 30 year TIP at 3% real makes him ask why a pension or insurer owns equities at all
A 20% equity drawdown would scare people but not change the economy, since the top 10% own most of the market and their spending barely moves; hosts counter that RSU driven layoffs and upper quintile consumption are real transmission channels, which he partly concedes
Mortgages and MBS (Minute 32)
He likes mortgage bonds now: think of a Fannie, Freddie, or Ginnie bond as akin to being long a ten year bond at 100 and short a three year call struck at 105
Current pickup is an additional 100 to 110bp of spread versus roughly 50bp for Investment Grade credit
The bigger driver of MBS spreads is the yield curve, not rate or vol level: the flat, inverted curve (two year up far more than ten year over recent months) explains spreads near 110 over versus a 75 long run average
GSE re-IPO and moral hazard (Minute 35)
He is firmly against re-IPO-ing Fannie and Freddie: privatizing gains for shareholders while socializing losses is classic moral hazard
Housing is 16 to 17% of the US economy; the government will always backstop the GSEs
He hints the investor base in GSE common stock explains the political push (“you kind of know what is going on here”)
What killed the GSEs pre GFC was running as government sponsored hedge funds, buying their own MBS, hedging with futures, swaps, and options to earn a spread, with management cashing options before the blowup. To recreate those incentives would be “nuts”
Why mortgage spreads move with the MOVE: MBS is short a call option, and option prices rise with implied vol; if the short call goes from four points to five, the bond drops from 96 to 95
The MOVE is an imperfect hedge vector for MBS: it measures one month vol while mortgages price off three to four year expiry options
Treasury vol no longer trades; swaption vol is the market since the early 2000s (Fannie and Freddie drove the shift): global liquidity, no repo or borrow costs, effectively infinite issue size
The Treasury basis trade and CTD risk (Minute 44)
The basis trade (long cash bonds, short futures) is now carrying water for the US government, absorbing supply; pension funds are the natural futures buyers, wanting thirty year duration off balance sheet while earning credit spread from five year corporates
The fragility: in volatile markets, cash and futures decouple, mark to market losses force risk manager stop outs, as seen when Treasury injected liquidity a few years back
CTD (cheapest to deliver) risk: each futures contract has a basket of deliverable bonds with conversion factors, like grades of wheat in Chicago; a rate shift can flip the deliverable from an eleven year to a nineteen year bond within weeks
If rates approach 6% again, “it will get very jangly” as futures holders stop knowing what they own; no defaults, just more volatility
Basis trade capacity is vol governed: risk models cut the trade exactly when the market needs absorption most; last cycle the funds actually won because the future extended duration faster than the cash bond
On persistently negative swap spreads since the GFC: Bassman says they reflect balance sheet costs and accounting constraints, not stupidity, and pushes back on the claim that synthetic long duration is necessarily expensive
His bigger worry: private equity firms building insurance companies and stuffing them with self originated private credit
Stocking stuffer: TIPS (Minute 55)
He will write his annual Christmas stocking stuffer note; TIPS will likely be the first recommendation
He believes realized inflation will exceed breakevens, and asks what a riskless real return should even be: T-bills have traded negative because you can put 50k in a mattress but not a billion dollars, so bills carry an insurance premium
Fair value for the three month real rate is maybe 0.5% at best; a 2.75 to 3% real yield on TIPS is “the wrong number” in the investor’s favor, and earning it outright is a good risk adjusted return
On purchasing power: he agrees CPI is a rigged number, engineered lower thirty years ago under Greenspan and Clinton (hedonic adjustments, 1990s healthcare changes), with every incentive to keep it low since Social Security and Medicare are indexed to it; understating CPI is a deliberate, slow motion deficit fix, and he can live with the smoke and mirrors “because plan B is worse”
What if Fed hike 100bps? (Minute 58)
A 100bps hike would produce a deeply inverted curve; Bassman repeats his summer call that the Fed should have done a one and done 50bps in July, since drip drip uncertainty creates volatility
He believes the data supported another 25bps in October but the Fed held for election optics, and thinks that was right: a pre election hike would have invited “the Fed rigged the election” claims
A 50 or even 100bps cut would not have changed the election outcome; voter unhappiness was already baked in
Silver lining: a path exists for Trump and Democrats to cooperate on “seventy thirty” issues where both sides win; impeachments or “nuttiness from either side” would be the disaster scenario
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