Bond and Stock Market Volatility Is Collapsing Post-QE3
If history is any guide, investors getting long that trade are flirting with disaster.
MINYANVILLE ORIGINAL Last week's stock market response to the QE announced the previous Thursday was rather muted as gains were consolidated with the S&P 500 (INDEXSP:.INX) closing down a mere five handles on the week. The Treasury market recovered from extremely oversold levels, but it was the mortgage market targeted by QE III that garnered the most attention and activity.
In this weekend's Wall Street Journal Weekend Investor section, Joe Light picks up on this price action and writes about investing in MBS mutual funds to take advantage of the Fed's QE III program.
The Fed said it would buy mortgage-backed securities, or MBS, for an indefinite period to bolster the economy. That could spell an opportunity for investors-and might warrant stocking up on funds that hold the securities, say analysts.
"At the very least, you want to overweight that sector," says David Ader of CRT Capital Group in Stamford, Conn. "That's the sector where you know you have a buyer of 100% of everything coming out for an indefinite period of time."
There is not an interest rate strategist on the street I respect more than David Ader, but here's the problem: Unlike most retail investors who are reading that article, Ader's clients are already overweight mortgages. The move has already taken place. From Bloomberg on Friday:
Mortgage-Bond Spreads Cap Biggest Weekly Drop Since December '08
A measure of relative yields on mortgage securities that guide US home-loan rates capped its biggest weekly drop in almost four years on speculation that the Federal Reserve will find a shortage of the bonds as it expands purchases.
A Bloomberg index of yields on Fannie Mae-guaranteed mortgage bonds trading closest to face value fell about 7 basis points, or 0.07 percentage point, today to a record low 61 basis points higher than an average of five- and 10-year Treasury rates as of 5 p.m. in New York.
This week's drop of 34 basis points, the largest since December 2008, exceeds the decline of 19 in the final two days of last week after the Fed's Sept. 13 announcement that it would expand its balance sheet with monthly purchases of $40 billion of government-backed housing debt until the economic recovery strengthens.
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?
The consensus concludes that QE III is focused on two objectives: One, lowering mortgage rates to help spur housing market activity, and two, raising the value of risk assets by inflating the currency. I believe both of these conclusions are misplaced and could turn out to be dangerous assumptions.
As I argued in Operation Twist II: Project Escape Velocity, I don't believe Bernanke is focused on lowering interest rates to help borrowers; I think he is targeting bank balance sheets. Due to rising savings and declining loan demand, the current aggregate loan-to-deposit ratio of US commercial banks is at 80%, which is near historic lows. As a comparison, that ratio was at 100% in 2008. At the same time, the ratio of securities held as a percentage of total credit assets is near historic highs with a large chunk in Agencies and MBS. According to Fed data, commercial banks are sitting on $2.6 trillion in securities comprised mostly of $1.3 trillion in MBS and $500 billion in Agencies and Treasuries.
Bernanke is trying to flush banks out of these bloated bond positions. He has already taken Agencies and Treasury yields to levels that have essentially removed any net interest margin that a bank can earn carrying these securities. The next assets on Bernanke's hit list are MBS and it didn't take long for the market to price this into spreads. With no spread left in MBS, the risk/reward for banks to own these securities is highly inverted. Before it even got started ,QE III had virtually eliminated the incentive for a bank to buy MBS.
At the September FOMC meeting, the Fed committed to keep the bank's cost of funds at zero until 2015; at the same time, it committed to remove the supply of MBS that bank can buy. To me, the message to banks is loud and clear: Your funding costs are staying low for at least three years, and you are not going to be allowed to sit in securities and make any net interest margin. Take the $2.6 trillion in securities and go makes some loans.
The velocity of money and the loan-to-deposit ratio are positively correlated. When the loan-to-deposit ratio falls, so too does velocity and vice versa. Bernanke knows that in order to increase economic activity and thus employment, he must get velocity moving again. To do this, he must incentivize banks to raise their loan-to-deposit ratio in order to get credit moving in the economy instead of sitting idle in securities.That is what I believe is the true target of QE III, not raising stock prices.
Nevertheless, the conspiracy theorist perma bears are convinced that Bernanke is targeting stock prices and they are capitulating left and right. Last week, the bearish contingency lost two of their biggest heroes as both Nomura's Bob "the Bear" Janjuah and Gluskin Sheff's David Rosenberg threw in the towel, attributing QE III as the catalyst.
Here's Bob the Bear getting stopped out of his August end-of-the-world-is-coming short call as cited in FT Alphaville:
We are four S&P closes away from being stopped out on the bearish call outlined in my August note. It seems.. that we were wrong to believe that central bankers would not become so "political"...
The S&P traded at 1425 on the day my August note with its 1450 S&P stop was released, the extraordinary central bank actions of the last few weeks has resulted in a very small hit to our year to date. As said, however, my stop loss will be triggered on this Friday's close if the S&P is still above 1450...
Real-world risk takers/investors may choose to exercise any such stop sooner but I will wait/accept the risk. But to reiterate, if the S&P closes above 1450 on Friday, the bear call of August is closed and initially at least I'd choose to go flat/neutral on a tactical basis.
He will wait and accept the risk of not having actually shorted the market at 1425, just advising you to do so because he didn't believe central bankers would be political. He's been wrong for the entire rally, and now at the top, he wants to blame easy monetary policy? That's asinine.
Then according to Business Insider citing his daily letter to investors, Breakfast with Dave Rosenberg is making a "compelling" case for equities due to low interest rates.
The economy and earnings are weak, and getting weaker, but the interest rate used to discount the future earnings stream keeps getting more and more negative, and that in turn raises the future profit expectations. It's that simple. And the fact that the S&P dividend yield is triple the yield in the belly of the Treasury curve has also lifted the allure of equities, or at least those that have compelling dividend yield, growth and coverage characteristics.
...[A]lmost 74% of the stock market movement can be explained by the level of the Fed's total assets ALONE since the QE1 announcement.
Give me a break. How do these people still have jobs? He's been pounding the table on low interest rates for years while still being bearish on stocks. Only now is he capitulating. Their analysis is wrong so they want to blame monetary policy. His bullish conclusion isn't even correct. In fact, I argue it's the opposite.
This is the proper way you analyze how the market prices risk premiums. From Helicopter Ben Rides Again:
Most consensus valuation models measure credit and equity risk premiums over the risk-free rate, normally the 10YR Treasury. I have found that a far more consistent benchmark to measure the premium is the YOY growth rate in the CPI. In fact, while the earnings yield on the S&P 500 will routinely trade at a premium to the 10YR yield, it rarely trades through CPI. Going back 40 years, only during the inflation spikes in the mid-1970s and early 1980s did you see the S&P trade through the CPI; the two biggest market tops of the subsequent bull market in 1987 and 2000 actually occurred when the earnings yield equaled the YOY CPI.
In other words, market valuation is much more sensitive to inflation and the discount of inflation than to the actual level of interest rates. In July 2008, the 5.6% CPI spike hit the S&P 500 earnings yield, which I believe was the final straw that broke the market's back.
I was attributing the 2008 financial meltdown not to the real estate bubble was crashing but to a spike in inflation from aggressive Fed easing.
The 2008 crash didn't happen because people quit paying their mortgages. It happened because of a rapid repricing of risk premiums in highly leveraged (short volatility/short gamma) positions due to a spike in inflation discounts that drove an eventual spike in implied volatility. The correlations between the dollar, commodity prices, the yield curve, and the risk curve are undeniable.
So in reality, what is causing these perma bears to flinch and go long is actually the biggest risk in the market. Yet both equity and bond investors are now sitting comfortably long, thinking they have the wind of the Bernanke put at their backs. But it is this put or the inflation he is trying to engineer that could cause market risk premiums to spike just like in 2008.
I think investors are making a dangerous mistake in extrapolating the cause and effect of QE I and QE II on asset prices and thus the effect of QE III. I addressed this last week in Analyzing the QE Meltdown, Ex Ante:
However, one of the biggest mistakes investors make is interpreting cause and effect in the market. It's easy to draw correlations to explain market behavior, but just because something appears to be related or was in the past does not mean that it is or will be in the future. Correlation does not imply causation.
The best advice I ever received was in 2006 when I was trying to short the market due to the housing market topping and a mentor told me sentiment is still too bearish, and there will be no bears left when this market tops. Well, today the bears are dropping like flies. QE III isn't causing risk assets to rise; it is simply the catalyst to bring in the last holdout market skeptics to finally capitulate and jump aboard the rally train.
I'm on the record as having been bullish for a long time. But when scared money gets long, I start to get cautious. The catalysts of extreme bearishness and skepticism that have been behind this rally are finally starting to wane. There could be more room to run, but we are in the late innings of this move and this is where it could start to get turbulent. Instead of subscribing to this QE III equals risk-on nonsense, I believe it's time to start playing defense.
I mentioned that implied volatility in the bond market as measured by the MOVE index was collapsing. You all know implied volatility has collapsed in the stock market as measured by the VIX, which has to be the most watched market indicator. I looked at both the VIX and MOVE together and rarely have they both been on their respective lows at the same time as they are now. The last time that was happening was in 2006 into early 2007.
So you are getting investors long both stocks and bonds predicated on what I believe is a false premise that QE III is bullish for risk assets. At the same time, both markets are short volatility into a potentially very volatile environment with inflation premiums on the rise. If history is any guide, investors getting long that trade are flirting with disaster.