Alarm! Big Short Resurfaces in U.S. Bonds, Wary of ‘Convexity Trigger’

Alarm!

It was great to be a “Master of the Universe” (Treasury and MBS trader) since October 1981 when the US 10Y Treasury yield peaked at 15.84% and mortgage rates peaked at 18.63%. Treasury and mortgage rates have generally fallen ever since. But what happens if Treasury and mortgage rates rise?

Bond investors are piling back into short positions, motivated not only by the specter of inflation but also by the risk that yields are approaching levels that will unleash a wave of new selling by convexity hedgers.

That level is around 1.60% in the U.S. 10-year Treasury yield, less than 10 basis points from its current mark, according to Brean Capital’s head of fixed income strategy, Scott Buchta. It’s the mid-point of “a key threshold” between 1.40% to 1.80%, an area “most critical from a convexity hedging point of view.”

Convexity hedging involves shedding U.S. interest-rate risk to protect the value of mortgage-backed securities as yields rise, slowing expected prepayment rates.

It’s already begun to pick up as yields stretched past the 1.40% level. Another wave is expected at around 1.6% — a point of “maximum negative convexity” in agency MBS, “where 25bp rallies and sell-offs should have an equal effect on convexity-related buying and selling,” Buchta says.

Signs that short positions are accumulating include Societe Generale’s “Trend Indicator.” Among its 10 newest trades are short positions in Japanese 10-year debt, German 5-year debt futures, U.K. 10-year gilts, U.K. short sterling and U.S. 2- and 5-year notes. Meanwhile, CFTC positioning data for U.S. Treasury futures show asset managers flipped to net short in 10-year note contracts in the process of dumping the equivalent of $23 million per basis point of cash Treasuries over the past week. Hedge-fund shorts also remain elevated in the long-end of the curve, as measured by net positions in Bond and Ultra Bond futures.

“Bond-bearish impulses remain in place,” says Citigroup Inc. strategist Bill O’Donnell in a note, citing tactical and medium-term set-ups. Traders should be aware of short-covering rallies in the meantime, however, he says.

“Potentially extreme short-term positioning and sentiment set-ups could easily allow for a counter-trend correction under the right conditions,” he said.

U.S. 10-year yields topped at 1.57% this week, the cheapest level since June, spurring the breakeven inflation rate for 10-year TIPS to 2.51%, the highest since May. Friday’s September jobs report could add fuel to this inflationary fire, rewarding bond shorts.

Here is a chart of the rising 10Y Treasury yield against The Fed’s 5Y forward breakeven rate.

Here is a Fannie Mae 3% coupon MBS. Note the rise in Modified Duration with an increase in interest rates.

Convexity for the FNMA 3% MBS?

There is something on the wing. Some-thing.

Pop Goes The Weasel! S&P 500 Drops 2% On Chinese Property Developer Contagion (VIX Spikes)

Pop goes the weasel!

(Bloomberg) — The S&P 500 Index extended its decline past 2% Monday afternoon amid growing investor jitters about China’s real estate crackdown potentially sparking a financial contagion. And the Hang Seng fell 3.30% overnight.

The benchmark gauge was down 2.1% as of 12:08 p.m. in New York. All of the 11 major industry groups declined, with the energy, financials and materials sectors leading the losses. The tech-heavy Nasdaq 100 index slumped 2.4%, while the blue-chip Dow Jones Industrial Average retreated 1.9%.

By 2:33pm, the Dow is down 2.55%, NASDAQ down 3.15%.

Volatility also soared, with the Cboe Volatility Index — often called Wall Street’s “fear index” — jumping as much as 29% to 26.75, the highest level in over four months.

“While the Evergrande situation is front and center, the reality is, stock market valuations are overstretched and the market has enjoyed too long of a break from volatility and Monday’s stock market declines are not surprising,” said David Bahnsen, chief investment officer at the Bahnsen Group, a wealth management firm.

As Evergrande bonds continue to tank.

Meanwhile, most commodity prices are falling … except for UK Natural Gas Futures which are up 16.5%!

Pop goes the weasel!

Kind Of A Drag! The Taper That Will Really Bite Into U.S. Growth Isn’t the Fed’s (As The Fed’s Repo Facility Hits An All-time High)

Kind of a drag … when Federal government stimulus fades just as The Fed tries to decide on slowing its balance sheet expansion.

(Bloomberg) — In the coming Year of the Taper, it’s the fiscal version that will really bite.

The chatter in U.S. financial markets is all about the Federal Reserve’s yet-to-be-announced reduction of its bond purchases. That’s obscuring something important: the already-under-way cutback of the federal government’s budgetary support — which is likely to have a much bigger impact on economic growth next year.

The U.S. expansion looks set to slow sharply in the second half of 2022 as measures that propped up the economy during the pandemic — from stimulus checks for households to no-cost financing for small companies — fade from view.

That will be the case even if President Joe Biden manages to win Congressional approval for the bulk of his $3.5 trillion Build Back Better agenda. The spending will stretch over years, with limited impact in 2022. It will also be at least partly paid for by tax increases that slow the economy down rather than speed it up.

And then the is Treasury Secretary Janet Yellen renewing her call for Congress to raise or suspend the U.S. debt ceiling, saying the government will otherwise run out of money to pay its bills sometime in October.

We can see the CDS market reacting … slightly … to Yellen’s concerns.

But next to Argentina’s CDS, the US looks positively tame.

And there is a little disturbance in the Fed Funds Futures volatility.

Then we have the volatility cube showing The Fed’s rate suppression at the short end and expected volatility in the future.

And there we have The Fed’s temporary repo facility hitting an all-time high.

Mercy, mercy, mercy!

U.S. Banks’ Loans and Leases Hit Historic Low (Residential Real Estate Loans Hit Historic Low As Percentage Of Total Bank Assets)

US bank loans and leases are slowing, yet The Federal Reserve has helped keep their stock values elevated thanks to the extraordinary monetary stimulus.

(Bloomberg) — U.S. banks’ loans and leases dropped to 47.15% of total assets in the week to Sept. 1 from 47.24% the week before, according to the Fed

Total assets increased to $22.19 trillion from $22.10 trillion

The share of safe assets — virtually riskless investments such as cash, Treasuries, and securities effectively guaranteed by the U.S. government — increased to 51.2% of total assets from 51.0%

Loans and leases as a percentage of deposits were unchanged at 59.7%
Cash was the highest as a percentage of total assets since January 2015
Residential real-estate loans hit a historic low as a percentage of total assets at 10.0%
Commercial real-estate loans were the lowest as a percentage of total assets since August 2015
Consumer loans were the lowest as a percentage of total assets since May
Commercial and industrial loans were the lowest as a percentage of total assets since June 2012

Only in this deranged, hyper-stimulated market can bank stocks be soaring despite slowing loan and lease growth.

Rent Inflation: National Average RENT Rose 10.3% YoY (Fed’s Got A Line On YOU!)

Not only after home prices screaming at near 20% YoY growth, but apartment rents are surging as well.

(Bloomberg) — Apartment rents were up in August from a year earlier in all the top 30 U.S. metro areas, the first time that’s happened since the start of the pandemic, according to a new report by Yardi.

The national average rent in multi-family buildings rose 10.3% from a year earlier to $1,539 — the first double-digit rise in the dataset’s history — after a $25 increase in August, the real-estate firm said. Over the past 10 years, the average pace of growth has been 2%.

Zillow’s rent index of all homes is growing at 9.25% YoY.

Fed Chair Jerome “Inflation is Transitory” Powell.

The Fed has a line on you! Or at least a bullseye on the back of renters.

Is it safe …. for renters?

Bond Market Set to Test Powell Push to Delink Hikes From Taper (As FANG+ Stocks SOAR With Fed Asset Purchases And ADP Added Only 374k Jobs In August)

Since the original model of The Federal Reserve was to purchase Treasuries and Agency MBS in an effort to push down interest rates, it will be quite difficult to delink the two: taper the balance sheet while not raising short-term rates.

(Bloomberg) — Bond investors may not wait long to start pushing back against Federal Reserve Chair Jerome Powell’s efforts to delink the start of asset-purchase tapering from the countdown to eventual policy-rate hikes.

Since Powell last week said the central bank could begin reducing its monthly bond buying this year, traders have stuck with early 2023 as the likely timing for the Fed’s liftoff from zero interest rates, and Treasury yields have barely budged.

But that calm faces a test starting Friday. The potential for volatility comes from the fact that when Fed officials gather this month, they will release fresh projections for the fed funds rate for the next few years. And with the labor market pivotal for Fed policy now, Friday’s August jobs report is seen as laying the foundation for these forecasts — collectively known as the dot plot — especially as some Fed officials have already been pushing for an early taper.

The upshot is that a robust reading Friday could have investors pulling forward tightening bets regardless of Powell’s efforts last week in his virtual speech at the Fed’s Jackson Hole symposium. The risk is traders will prepare for a repeat of June, when a hawkish signal via the dot-plot took markets by surprise and triggered an abrupt unwinding of wagers on a steeper yield curve.

If the employment report is “even deemed acceptable, regional presidents will be back on the tape in a flash,” sounding hawkish again, said Jim Vogel, an analyst at FHN Financial. “And you may have more officials penciling in a 2022 hike. And that would have to flatten the yield curve.”

Expectations for a hawkish shift would lift 5-year Treasury yields in particular, shrinking the gap with 30-year rates, Vogel said. That spread was around 114 basis points Wednesday, down from about 140 just before the Fed met in mid-June.

Dots Math

Officials’ June quarterly forecasts not only showed a median funds rate projection of two hikes in 2023 — after the March dot plot indicated no tightening until at least 2024 — but that seven participants saw at least one increase next year. This time around, it will take just three officials to raise their dots for 2022 for a full hike to be the new median for next year, assuming everyone else keeps their projections where they were.

Traders responded to the Fed’s June rate projections by driving 5-year yields up the most in almost four months. That was even as Powell said in his press conference that the dot plot should be taken with a “big grain of salt” and discussion about raising rates would be “highly premature.”

Powell last week said “the timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test.”

But the leadup to the Fed decision on Sept. 22 may culminate in a dot-plot unveiling that yet again presents a communication challenge for policy makers, as has been seen several times since the Fed introduced the projections in 2012.

“There’s information in the dots, and generally it’s good information,” said Shahid Ladha, head of Group-of-10 rates strategy for the Americas at BNP Paribas SA. It makes sense for the Fed, regarding tapering and rate hikes, “to try to separate them, but I don’t think they’ll be ultimately successful in separating them.”

Trouble Ahead

Even some Fed officials are wary of being able to disentangle the tapering from rate hikes, minutes from the July Fed meeting showed.

Kevin Flanagan, head of fixed-income strategy at WisdomTree Investments Inc., which runs exchange-traded funds with assets of $75 billion, sees trouble for the Fed.

His view is that the labor market will keep gaining ground in its rebound from the pandemic, and that the median September dot may show a hike in 2022. That bodes for higher yields, a flatter curve and makes floating-rate notes appealing, he said.

The median of economists’ projection is for a gain of 725,000 jobs in August, a slowdown from June and July but well above the average for 2021. Of course, with millions still out of work relative to pre-pandemic levels, the Fed may prove to take longer to lift rates than traders expect, especially given the central bank’s “broad and inclusive” maximum-employment goal. But the market may be about to challenge that approach.

Note: Yesterday’s ADP jobs gain was forecast to be 625k jobs added in August, but only 374k jobs were actually added.

Fed Faces ‘Ugly Fight’ Over Jobs Goal in Next Big Policy Debate

“We are going to be all of a sudden talking about rate hikes potentially next year, and that is where the focus of the bond market is going to go,” Flanagan said. “The dot plot will be the Fed’s initial message for its forward guidance on rates. And then it will begin to come from Fedspeak — which is when the rubber will really meet the road.”

And with the stock market, particularly technology stocks, rising with Fed asset purchases, I wonder if The Fed forecasts that assets prices will keep going if they withdraw the punch bowl?

Let’s see if Powell and The Gang can forecast the stock market if they taper the balance sheet and raise rates.

The Powellenburg Omen Is Flashing … Again (ECB Balance Sheet Is 79.62% Of European Union GDP)

Well, the US stock market is raging along with Federal Reserve monetary stimulus, Federal government fiscal stimulus and a roaring economy.

A note of caution: the Hindenburg Omen chart is flashing … again. It forecast the stock market crash of 2008, but growing monetary stimulus from The Federal Reserve (green line) has helped prevent another correction.

The Shiller CAPE ratio is signalling a correction just like the Hindenburg Omen.

But Fed Chair Powell and Treasury Secretary Yellen along with our free-spending Congress and Administration have nothing on Europe where the ECB’s balance sheet is a whopping 79.51% of European Union GDP! The Fed’s balance sheet is “only” 36.66% of US GDP.

Here is the SS Powellenburg cruising over Wall Street.

DOVE Alert! S&P 500, Gold, Bitcoin Rise After Powell Goes Full DOVE, UST 10Y Yield Falls

Well, I was expecting a little more guidance than Fed Chair Powell gave today at the J-Hole conference. In fact, failing to give a hard date on paring back the balance sheet and raising rates is downright dovish. A regrettable incident.

As a result of Powell’s dovish talk, GOLD, BITCOIN and the S&P500 index rose.

The S&P 500 index rose almost 1% today while the 10Y Treasury yield dropped 4 bps.

Fed’s Ability to Set Rates Floor Is Weakening on Cash Deluge (“Charming” Powell Had At Least 350 Meetings, Dinners Or Phone Calls With Members Of Congress)

Powell and The Fed’s policies have veered from their mandate requiring Chairman Powell to meet 350 times with Congress to sell The Fed’s policies.

Bloomberg) — The Federal Reserve’s floor for overnight funding markets is proving to be no match for the deluge of cash.

Money-market securities ranging from Treasury bills to repurchase agreements continue to trade below 0.05% — the offering rate on the overnight reverse repo facility, which is supposed to act like a floor for the front end. The Fed at its June meeting had raised the rate by five basis points to help support the smooth functioning of short-term funding markets.

Still, usage of the tool climbed to a record $1.136 trillion on Monday, eclipsing the previous high of $1.116 trillion on Aug. 18.

Demand for the so-called RRP facility has surged as a flood of dollars threatens to overwhelm funding markets. That’s in part a result of the central bank’s long-standing asset purchases and drawdowns of the Treasury’s cash account, which is pushing reserves into the system. As a result, liquidity has been swelling, especially as the Treasury cuts supply to create more borrowing room under the debt ceiling.

The pressure pushing down overnight rates toward zero is proving a major headache for money-market funds. It hampers their ability to invest profitably, and can lead to further disruptions as they begin to waive fees to avoid passing on negative rates to shareholders. A number of firms including Vanguard Group shut down prime money-market funds last year after struggling to cover operating costs in the low-interest-rate environment.

Yes, overnight rates such as the US SOFR rate, are near zero.

Powell’s Charm Offensive in Congress Positions Him to Keep Job

Perhaps that is why Federal Reserve Chair Jerome Powell is acting as a lobbyist with Congress for The Fed’s nontraditional approach to monetary policy.

(Bloomberg) Since he took the helm of the Fed in February 2018, through June of this year, he’s held at least 350 meetings, dinners or phone calls with members of Congress, according to his monthly calendars. That’s almost nine per month, and many of those included more than one lawmaker. The tally doesn’t count at least 16 appearances as chair before numerous congressional committees.

Well, the stock market has zoomed-up since Bernanke and The Fed adopted zero-interest rate (ZIRP) policies and the now famous quantitative easing (QE) policies in late 2008.

Congress member Alexandria Ocasio-Cortez asked Fed Chair Powell about the Fed helping with US unemployment. We are already at zero rates (on the short-end), and Congress should look at their policies on why labor force participation is slow to recover from the Covid epidemic.

Powell is sounding more and more like Parks and Recreation’s Tom Haverford in terms of schmoozing Congress for support.

Update: The Mises Stationarity Index is flashing “BUBBLE.”

The Mises Stationarity Index is different than the Shiller CAPE index, which is showing equities as being overpriced, but not yet in dot.com bubble zone.

Treasury And Mortgage Rates In A Never-Ending Balance Sheet World (REAL Mortgage Rates NEGATIVE With Skyrocketing Home Prices)

Headline! “Fed’s Kaplan says delta variant could cause him to rethink his tapering view”

Face it, the Federal Reserve may alter its growth path on asset purchases of Treasuries and Agency Mortgage-backed Securities, but it is doubtful that they will pare back their balance sheet. Call it “A Never-ending balance sheet for you” world.

Why? Seemingly never-ending Covid crisis, etc.

Let’s look at US Treasury yields today. The 10-year Treasury yield is up slightly to 1.25% as of 10am EST.

Here is a chart of the 10-year Treasury yield, Fed Funds effective rate, Fed Balance sheet and reverse repos since the Covid outbreak and Fed massive intervention. Bottom line, the have repressed the short-term interest rates and put downward pressure on the 10-year Treasury yield.

As the 10-year Treasury yield remains repressed DESPITE HIGHEST INFLATION RATE SINCE 2008, the Freddie Mac 30-year mortgage rate remains repressed as well. Yes, that mean NEGATIVE REAL MORTGAGE RATES.

This produces a REAL mortgage rate of -2.56%.

The spread of mortgage rates over the 10-year Treasury yield is about 173 basis point since 1971.

Where will Treasury yields go from hear? If we believe technical analysis like the Ichimoku Cloud, the 10-year Treasury rate will likely rise.

And The Fed’s Dots project also see rates rising (at least on the short-end.

Negative real mortgage rates and blistering home price growth?

Will the attendees at the KC Fed Jackson Hole conference discuss these matters? Or will it just be a Federal Reserve Soul Shake (dance)?