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Bond and Stock Market Volatility Is Collapsing Post-QE3

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If history is any guide, investors getting long that trade are flirting with disaster.

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After I read that Bloomberg article on Friday, I ran my own chart of its 30YR MBS index and overlaid it with the spread over just the 10YR yield. The index closed at a yield of 1.80% and a spread over the 10YR at 5bps or 0.05%. To give you an idea of the magnitude of the recent tightening, that spread was 100bps on June 1 and had never before been inside 50bps. You will recall June 1 was the day of the May NFP release that only saw a 45k increase in payrolls. The MBS market has been pricing in QE III ever since.

Mortgage yields aren't the only spreads that have collapsed to zero. The 10YR swap spread, which mortgage investors use to hedge convexity/gamma risk, has also tightened. This past week, it nearly hit zero, closing at 1.44bps down from recent highs at 20bps (which was also at the beginning of June).

Don't stop there. Bond market implied volatility as measured by Merrill Lynch's MOVE index hit near 20 year lows below 60, which is a level breached only twice over that time span. The first time was in the summer of 1998 before Long-Term Capital Management imploded as a result of a short volatility convergence trade that blew up due to a volatility spike when Russia defaulted. The other time was in early 2006 into 2007 when investors shorted volatility in the form of credit derivative structures until the Bear Stearns Credit hedge funds imploded in July 2007.

Due to the prepayment option, mortgage securities are short interest rate volatility. Because the Fed has committed to removing virtually all new origination supply from the market for the foreseeable future, thus keeping a lid on mortgage yields, the need to hedge negative convexity risk via swaps, or volatility risk via options, has been dramatically reduced. However, with mortgage spreads trading on top of the 10YR Treasury yield, MBS buyers are now receiving no premium for selling the prepayment option. Mortgage investors are effectively naked shorting volatility at zero in negative gamma positions with bond market implied volatility at historic lows. What could go wrong?
No positions in stocks mentioned.
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