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Tyler Durden, "Fight Club" (1999)
Punta del Este | Last week our comrade at Zero Hedge astutely noted that, in the October 2012 FOMC minutes, Fed governor and soon to be Chairman Jerome Powell opined that the Fed has a “short” position in volatility. Powell said:
“[W]hen it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position.”
Of course, none of the economistas who supposedly follow the Fed for a living actually noticed Governor Powell's honest comments about how unwinding a short position in volatility might impact the markets. As we noted at the end of last year (“Banks and the Fed’s Duration Trap”), the Fed’s open market purchases of securities or “QE” has taken trillions of dollars in bonds out of the market, effectively reducing the amount of securities or duration available to private investors.
The Fed’s $4 trillion or so in Treasury securities and mortgage backed securities (MBS) is not hedged, thus the Fed is long duration and has capped volatility in the markets as a result. Securities trading volumes by banks are also lower as a consequence of QE, hurting bank earnings. Most large banks have guided down trading revenue for Q4 ’17.
But when Powell said that the Fed would “sell” $20 billion per month, he actually misspoke. The Fed is not going to actually sell any securities. And is his comment about the Fed having a “short volatility” position correct? We think not. Mark Dow on Twitter noted:
"Being long MBS you are implicitly short treasury volatility. This is what Powell meant. The tinfoil hat charlatans left it ambiguous so that their readers would infer all kinds of nefarious direct manipulation of the VIX."
Volatility is commonly viewed as a statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by using the standard deviation or variance between returns from that same security or a market index such as the S&P 500. But like measuring "liquidity," trying to quantify forward price movements of a security based upon past data is a fool's errand. Students of Dow theory know that the past tells you nothing about the future.
Yet since the Fed has suppressed interest rates and credit spreads through purchases of Treasury debt and MBS, is the central bank really “short” volatility? No. The Fed is certainly long duration, which is why the Federal Open Market Committee will not actually be selling any securities from the portfolio. Instead, as we discussed with Bob Eisenbeis of Cumberland Advisors in December, the FOMC intends to merely end its reinvestment of cash when securities are redeemed. That’s it, no outright bond sales.
So is the Fed short volatility? No, but that is the joke on all of us. Thanks to the Fed’s manipulation of the credit markets, we are all short-volatility. The mostly commonly discussed measure of volatility is the VIX contract traded on the Chicago Board Options Exchange (CBOE). Unlike measures of actual market volatility, the VIX is a popularity contest; the measure of expected future volatility which is generally calculated as 100 times the square root of the expected 30-day variance or value at risk (VaR) of the S&P 500’s rate of return.
By holding down bond yields and, indirectly, compressing credit spreads, the FOMC has reduced actual volatility and, more important, also gradually reduced the market’s expectations for future movements in the prices of securities. Chart 1 below shows the VIX over the past five years along with the spread between the 10-year Treasury bond less the 2-year Treasury note. Observe that as the Fed prepares to end bond purchases, the VIX has reached all-time lows. Expectations, after all, are a lagging indicator.
Former Fed Chairman Ben Bernanke has argued that the FOMC should not begin to shrink its balance sheet until short-term interest rates are well away from their effective “lower bound,” one the magical terms employed by economists to convey the impression to the public that they know what they are doing when it comes to financial markets.
Yet as we and a growing number of investors seems to appreciate, the Fed cannot force up long term rates so long as it is sitting on $4 trillion worth of securities that it does not hedge. More, given that the Treasury intends to concentrate future debt issuance on short-term maturities, downward pressure on long-term bond yields is likely to intensify, as Eisenbeis observes in his most recent comment on the FOMC minutes.
What the FOMC has done to the markets via QE is essentially reduce potential volatility by holding securities and not hedging these exposures. The European Central Bank and Bank of Japan (and all global; central banks) do the same by purchasing securities and not hedging against price movements. In normal times (whatever that is), central bank purchases were so small relative to the markets that actual volatility served as a good indicator of future risk. But today, in the induced coma known as QE, measures of volatility are suppressed along with bond yields.
Thus ZH asks the obvious question: How does Powell feel about volatility today? Dan writes: “Maybe someone can ask Powell at the next FOMC press conference just where that stands today, and whether he is still as skeptical the Fed will succeed in unwinding its balance sheet, as he was in October 2012.” ZH also quotes Powell on the risks of ending QE:
“My third concern—and others have touched on it as well—is the problems of exiting from a near $4 trillion balance sheet. We’ve got a set of principles from June 2011 and have done some work since then, but it just seems to me that we seem to be way too confident that exit can be managed smoothly. Markets can be much more dynamic than we appear to think.”
Yes, markets can be dynamic when they are allowed to operate. The whole point of QE has been to prevent the normal operation of the financial markets. As we all know, the social engineers on the staff of the Federal Reserve Board in Washington have a huge God complex. The Fed’s gnomes think they can manipulate markets with no downside risks. But they also fear taking losses on the Fed’s portfolio for fear that it will awaken critics of the central bank in Congress.
So while the Fed is certainly long duration, we dear friends are short volatility thanks to QE. Or as Grant’s Interest Rate Observer said so well: “The Fed is selling, you are buying.” As the Fed ends its reinvestment of cash when bonds redeem, volatility will return to the markets, spreads will widen and trading by private investors will rebound. A lot of market participants will get their eyeballs ripped out when the weight of option-adjusted duration shifts back to private investors. Can't wait.
"What everyone is missing is that as the US Treasury and MBS holdings roll off, the duration of their overall holdings is hardly affected," notes industry veteran Alan Boyce, referring to the possible extension of the MBS. "It is the higher coupon MBS plus the 15 year paper that are going to prepay. The new Fannie Mae 3s are not going anywhere. On the US Treasury side, ZERO of the long bonds are going away, they will just slowly March down the yield curve over the next 30 years. Amazing but true, the FOMC's taper could result in longer aggregate effective duration of System holdings even though the footings shrink."
The return of market function, however, will spell bad news for the Fed’s MBS portfolio, which will decline in price faster than the market thanks to the convexity of mortgage securities. But as Boyce notes, the portfolio will also extend in duration as prepayments slow. This is just one reason why we don’t expect Chairman Powell to have a lot to say about volatility in future utterances. Fed Chair Janet Yellen and the majority of the FOMC have created a trap for themselves and Powell get’s to clean up the mess.
The FOMC cannot sell securities without creating losses for the System Open Market account, thus triggering criticism from the Republican majority in Congress. But they cannot hike short-term interest rates three more times in 2018 as currently planned without inverting the Treasury yield curve and provoking fears of a recession.
In order to manage the normalization of interest rates, the Fed ought to be selling the bonds and MBS, TBAs and dollar swaps to force long-term yields higher and thereby maintain a relatively normal curve. Hell, the Fed could even buy some mortgage servicing rights or MSRs as a hedge against its MBS. But that would require imagination and courage.
A flat curve will be bad for financials, which are already facing an earnings bloodbath in Q4 ’17 thanks to reduction in corporate tax rates (and a commensurate mark-down in the value of tax loss carry forwards). Lower trading volumes will likely also be a negative for bank earnings this quarter. And lending volumes in just about every bank asset class are also soft, begging the question as to when big bank equity valuations will reset.
More important for Chairman Powell, a flat yield curve will demonstrate to the markets and Congress that the majority on the FOMC has not the slightest idea how their policy moves impact the real world of money and credit. Powell certainly seems to get the joke. His first challenge as Fed Chairman may be navigating the dangerous political mess created by Chairman Bernanke and Chair Yellen, who actually seem to think that the US bond market can endure several years of an inverted yield curve as we wait for the Fed’s portfolio to run off before the central bank completes the normalization of policy.