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Bond Market Convexity: Objects in Mirror Are Closer Than They Appear


It's uncertain whether we're seeing a trend change in interest rates or the continuation of the deleveraging process.

To provide another comp, in the second half of 2011, when banks added a similar $266.7 billion in total credit assets, securities represented only $84 billion of the growth (32%) versus loans of $178 billion (68%). The typical allocation breakdown during expansions in the 1990s and 2000s was closer to 80/20 loans versus securities. Even in the second half of 2008 as the wheels were coming off, total banking credit increased by $321 billion, of which $300 billion (93%) went to loans and only $21 billion went into securities.

The point of this analysis is twofold:

First was to demonstrate that by calculating how banks are allocating credit assets between loans and securities, it does not appear that the demand for credit is increasing, and it could actually be decelerating.

Second is that I now want to demonstrate how these bloated securities positions on bank balance sheets represent significant systemic risk with exponential effects on bond market volatility and thus the interpretation of the market discount.

As I posited earlier this month in What's Driving Intense Volatility in the Bond Market? one of the three possible explanations was convexity selling by MBS holders. Banks hold a large portion of their securities assets in callable and hence negatively convex bonds. I have been concerned about the negative convexity risk on bank balance sheets since last June when I wrote In The Parallel Universe, Credit Risk is Interest Rate Risk:
The Fed likes to extol the benefit of low interest rates on borrowers without discussing the costs to the lender/investor and it's not just in lower yield. The lower the coupon for a given duration, the more volatile that coupon becomes. Currently (with virtually the entire curve sporting negative coupons) there is tremendous embedded volatility on bank balance sheets. Add to that the fact that the banks' holdings are primarily callable and thus short convexity, and you have the recipe for a very unpleasant situation when rates start to rise.

Convexity can be thought of as the second derivative of duration. Bonds that are positively convex rise more in price when yields fall and fall less in price when yields rise. Conversely, bonds that are negatively convex rise less in price when yields fall and more in price when yields rise. This is also known as extension risk: When rates rise, what was once a short callable becomes a long bullet increasing the duration, and thus mark to market risk on a bank's balance sheet.

The reason objects in mirror are closer than they appear is due to convexity. The shape of the mirror is convex and this distorts the images it reflects. The same can be said for convexity in the bond market. which can distort the duration of your portfolio, and in a bank's case, the balance sheet.

If you have a negatively convex portfolio when interest rates fall, it will look to be very short duration, and when they rise it will look to be very long. As a consequence, when interest rates fall, you may tend to buy more duration, and conversely, when rates rise, you may tend to sell more duration. To the fixed income value investors this is completely illogical -- buying more when prices are high and selling more when prices are low.

This is the reflexive nature of the bond market in action, and if this occurs systemically at extremes, convexity hedging can magnify the impact of interest rate movement and thus the interpretation of the discount. For example, when falling interest rates trigger more duration buying, further pushing interest rates lower, this may be incorrectly interpreted as deflationary. When rising interest rates trigger duration selling, pushing interest rates higher, this may be incorrectly interpreted as inflationary.

As I noted, in the second half of last year banks loaded up on very low coupon negatively convex assets as interest rates fell to a record low. Then in December, Congress failed to extend the so-called TAG FDIC insurance on unlimited amounts of non-interest bearing deposits. The long end of the yield curve was already rising due to the weakening yen and rising stocks. Banks had to sell securities to meet those redemptions, which is why you see a slight dip in securities holdings and even large dip in the ratio to total credit. Because duration was already extending they likely sold more duration, which caused interest rates to rise further driving more duration extension.

US Bond Futures Weekly

This duration selling pushed the US bond futures contract right into my 143-00 objective and the market has been battling ever since. Now the 143-00 pivot level into the rising trend line carries even more significance. If this area fails because the demand for money is increasing then convexity selling will intensify, increasing pressure on bank balance sheets just as they will need liquidity to extend credit. If 143-00 holds then the demand for credit isn't increasing and we just witnessed a minor convexity blowout head-fake. I suspect this will be reconciled in the coming weeks.

In September the Fed told the banking system they were going all in on MBS pledging to remove virtually 100% of new production from the market. In December they added US Treasuries and said the program was open-ended until specific economic conditions are met. Then just over a month later comments from various Fed officials suggest they are backtracking.

As I mentioned last week in Bank of Japan Meeting: The St. Valentine's Day Massacre, noted dove Charles Evans, for whom the open-ended QE is named, sounded off on reducing the pace of asset purchases even if the unemployment rate doesn't meet his and the FOMC's stated objective of 6.5%. The so-called tapering of QE as highlighted by Kevin Ferry on the Contrarian Corner and discussed by Minyanville's Michael Sedacca was again floated last week by Jim Bullard and Sandra Pianalto.

Do these Fed officials believe that economic growth is accelerating, or are they just worried about the perception of extremely accommodative unorthodox monetary policy as stock prices blow off to new all-time highs?

I don't know if they are truly drinking their own Kool-Aid or whether they are simply trying to quell expectations of unlimited QE due to excessive speculation. What I do know is that by floating the tapering idea, the Fed is in effect looking to change the rules of the game after the bets have been placed. Due to the systemic risk embedded in the banking system's high concentration of securities, this is a very dangerous game. Thus far the damage has been minimal and we still don't know if this is the beginning of a change in trend in interest rates or whether we have more wood to chop in this deleveraging process. My hunch is it's the latter, but a massive negative convexity blowout may be much closer than it appears.

Twitter: @exantefactor
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