The Convexity Maven

From Benny & The Squirrel · 1:01:22

Show by Benny & The Squirrel

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. Benny & The Squirrel is a reader-supported publication. To receive new posts and support my work, consider becoming a free or paid subscriber.Show NotesHow 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 repeatedlyWhat 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 IIThe 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 terribleThe 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…

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