FOMC Preview: Forget the DOTS
Focus on the end of the balance sheet contraction; date, size and composition
For those that caught Bloomberg TV’s The Open this morning I hijacked the Fed preview discussion from the DOT plot to the balance sheet contraction and the impact on fixed income implied volatility. Here is a quick note to elaborate on the Fed’s balance sheet and volatility suppression.
Perhaps the most underappreciated effect of large-scale asset purchases (QE) was the suppression of fixed income volatility as the Fed took the single largest source of volatility - mortgage prepayment risk - out of the market. Here is a regression of the option - a 3 year option on 10 year rates expressed in basis points - that most closely replicates the volatility component of a newly created 30 year fixed rate mortgage and 10 year real rates (TIPS yields) prior to the global financial crisis.
In 2002, when the Fed was reducing the federal funds rate to 1% amidst the TMT investment bust, a massive refinancing wave drove mortgage volatility to unprecedented levels. Fannie Mae made the fateful decision to stop hedging and allowed their duration position to expand to short the equivalent of ~$110 billion 10-year Treasuries. By August market participants had uncovered the position, Fannie spent September covering their short in swaps and mortgages. There were Congressional hearings, legislation to strengthen the regulator and from that point through the Financial Crisis Fannie and Freddie kept their duration at zero. They refocused on credit risk and leverage, but that’s a story for another day.
Many will recall Bloomberg messages from mortgage desks with the precise amount of ‘convexity’ related selling or buying for a given move in Treasury yields on payroll Fridays as Fannie and Freddie mechanistically hedged their $1 billion retained portfolios. This approach to hedging explains the negative correlation between real rates and implied volatility, lower rates meant increased mortgage prepayments at a non-linear or convex rate and higher implied volatility.
From the launch of QE2, beginning with the KC Fed Jackson Hole Economic Symposium in late August 2010, through the Taper Tantrum in June 2013, the relationship between real rates and implied volatility was turned upside down. As the Fed was accumulated 30-40% of the outstanding stock of Treasuries and agency mortgage backed securities, they drove rates and vol lower. This period of volatility suppression created a reach for yield, and in our view, impaired creative destruction allowing inefficient companies to get financing and thereby contributing to weak productivity growth and low labor market dynamism.
For tomorrow’s FOMC meeting we do not think you should focus on the DOT plot, our proxy for Fed policy expectations; 3 month rates 18 months forward less the 3 month rate settled at -8bp today. In other words, a couple of FOMC participants would have to forecast a cut with no hikers to move the Dot plot below zero, a very unlikely outcome. Instead, the Fed has made it clear the next policy step is announcing the timing of the end of balance sheet contraction, as well as the size and composition.
It has always been the FOMC’s intention to get out of the credit allocation business and, though they have never explicitly mentioned it, volatility suppression by evolving towards an all Treasury portfolio. This implies transferring the single biggest source of interest rate volatility; US 30-year fixed rate mortgage prepayment risk, to the private sector. Additionally there have indications they would prefer to shorten duration of their Treasury holdings, a reverse ‘Operation Twist’ or bear steepener. We suspect they will ‘taper’ the balance sheet restructuring. However, one final note from our third chart; our mortgage volatility proxy, 3y10y swaption volatility is at an all time low. Both the February and October 2018 equity market corrections began with long term real rates and fixed income volatility spikes the prior month. We aren’t ready to cut equity risk, however, getting long fixed income vol looks like excellent risk/reward.
Barry C. Knapp
Managing Partner
Ironsides Macroeconomics LLC
908-821-7584
https://www.linkedin.com/in/barry-c-knapp/
@barryknapp
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