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Deviate & Resonate ( Article 1)

US Interest Rate and MBS market structure

One of the underappreciated properties of Complex System is: They are characterized with long period of statis, marked by sudden catastrophic failure. Perhaps from this property only market has got sayings: “In market nothing happens in years and decades happens in weeks”.  Our memory of March 2020 is still fresh I guess.

There was a sharp movement of US 10 Year yield in last 3-4 months, US 10 year closed at 1.625% on Friday. Just to put in perspective 10 Year UST touched 0.53% in July and it was at 0.91% in December. Last week was one of the worst weeks in long time.



It appears that current move of reflation trade (Expecting Inflation and Normalising of economy) is overextended and yields may cool in coming months.







However something else happening in the US Bond market which is super interesting. As mentioned by Harley Basseman (The Convexity Maven) in his interview with Michel Green (Logica Capital Advisor), that entire market structure has changed and that is something we should take serious note on.

There are two nuanced point on US long term interest rate: Term Spread and Implied Volatility.

  •  Term Spread: Difference between 1 Year and 10 Year Yield is known as Term spread
  • ·Implied Volatility: Expected volatility of a security (10 Year Bond Price in this case) over the period of option.

At present while 10 Year yield is going up but 2 year yield is flat and hence Term spread is higher. Now normally this increase in Term Spread should had accompanied by increase in Implied Volatility making any one who want to take insurance (Option on 10 Year Rate) against perceived rise in Interest rate.

Surprisingly same is not happening depriving market with automatic stabiliser. Question to be asked is why is it happening?

As it turns out that one of the major player in Interest rate Option market was Freddie and Fannie, a 1 Trn $ hedge fund. They required taking option to hedge their mammoth position in Mortgage Backed Security.













So What has Changed:

Post Global Financial Crisis market of MBD has gone structural change. Major Player in US MBS market is now FED and ETF. 1/3rd of MBS is in the books of FED who doesn’t have a stress of mark to market the security and another 1/3rd of the MBS is held by Investors through ETF. Now for ETF if a duration change from 7 years to 9 years when interest rate goes up it doesn’t matter, they don’t hedge their position. This change in market structure has led to lower implied volatility in long term rate market.

What does it suggest:

Due to changed structure is true price discovery has got impacted. This is one more example of market getting intoxicated by every incremental dose of liquidity by FED. Question to be asked is what will happen once there will be call for redemption from ETF holder.

It leads to same conclusion that conventional matrix of stability might be delusional.

There is lot of fragility in financial system and it’s beyond comprehension that what event can trigger what consequence.

Only way to deal with such fragility is to ensure enough protection in the portfolio so that extreme movements don’t impact portfolio beyond repairs.

 

 


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