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Time for Another Convexity Crisis?

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Photo Credit : Loren Javier || Maybe Convexity crises are like Heffalumps. They only come if you whistle, and only if the time of year is right…

Everyone remember 1994, when mortgage convexity forced the Fed to raise the Fed Funds rate? Or 2004, when the same thing happened in a more minor way?

Well, at present, long Treasury rates are rising. I think it is because the economy is booming, and we don’t need more “stimulus.” Note that labor employment is a trialing indicator and is the worst variable to base monetary policy off of, because it will constantly make monetary policy overshoot. If you want a stable fiat money monetary policy, go back to the ideas of Knut Wicksell, and use the slope of the yield curve as your target. Interest rates are forward-looking. Monetary policy can’t directly affect labor employment. Jobs get created on a lagging basis as the recovery occurs. If you are waiting for jobs to be created in order to begin tightening, monetary policy will create bubbles, lie we are seeing now, and you will be too late to tighten, creating more crises. Note that crises have become more common as we rely on monetary policy to do the impossible.

Well, what else is rising now? Mortgage rates, and the ICE MOVE index (interest rate volatility). What’s falling? The repo rate on the 10-year Treasury note, which went to -4.25% yesterday at its nadir, closed at negative -0.5% as the Fed lent roughly 85% of its on-the-run 10-year notes into the market.

Things are weird, and there is no telling what may come of this. The Fed is of course “lost at sea” as it thinks it is all-powerful when it can’t discern what is going on in the bond market. Yes, the Fed will adjust (late) to a crisis, but it is certainly not all-seeing.

I’m not saying there will be a panic as in 1994 or 2004, driven by mortgage hedging. That said, there are some straws blowing in the wind to that effect. To the degree that hedging goes on in the mortgage markets, whether by originators or portfolio investors, after rates have hit new lows, and rates rise rapidly, the possibility of a self-reinforcing rise in rates can’t be discounted.

As it stands now, the equity market as a whole is priced to return less than a 10-year Treasury Note at present over the next ten years. When valuations are this high, it doesn’t take much to create a panic. We are in the 98th percentile of valuations now, akin to the dot-com bubble.

So, if you think that this is a reasonable hypothesis, the rational thing to do is raise cash. Sell stocks, reduce bond duration, give up income to preserve capital.

(Now, I don’t trade that much, so my cash levels have been rising slowly over time. Do I assume there will be trouble? No, but I have balanced the risks of being in the market and not being in the market. Aside from that, the stocks I own are out of favor, and their valuations are close to the bottom of market levels, so I am not too concerned.)

Regardless, take account of your portfolio and decide whether you need to take some risk off the table. Personally, I think this is an era where there is not much additional upside under any circumstances for a portfolio that is like the S&P 500, much less large growth stocks. But make up your own mind, and balance return versus risk.


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