Since last week was a work deadline, I missed all the fun. I’m late to the inflation worries debate, but I think Martin Wolf got it right:
what is the disagreement? Prof Ferguson made three propositions: first, the recent rise in US government bond rates shows that the bond market is “quailing” before the government’s huge issuance…
The first point is, on the evidence, wrong. The jump in bond rates is a desirable normalisation after a panic. Investors rushed into the dollar and government bonds. Now they are rushing out again. Welcome to the giddy world of financial markets.
At the end of December 2008, US 10-year Treasury yields fell to the frighteningly low level of 2.1 per cent from close to 4 per cent in October (see chart). Partly as a result of this fall and partly because of a surprising rise in the yield on inflation-protected bonds (Tips), implied expected inflation reached a low of close to zero. The deflation scare had become all too real.
What has happened is a sudden return to normality: after some turmoil, the yield on conventional US government bonds closed at 3.5 per cent last week, while the yield on Tips fell to 1.9 per cent. So expected inflation went to a level in keeping with Federal Reserve objectives, at close to 1.6 per cent. Much the same has happened in the UK, with a rise in expected inflation from a low of 1.3 per cent in March to 2.3 per cent. Fear of deflationary meltdown has gone. Hurrah!
That image is from that article. I want to drill down into the upper-right graph. We don’t need to “guess” what the market thinks of inflation; the market tells us. Here is the upper-right graph reproduced:
Inflation is simply the 10-year Treasury Notes minus the 10-year TIPS. The only difference between the two lines above is that the TIPS principal is adjusted for inflation. So the difference is the market expectation of inflation – if it wasn’t, we’d expect arbitrage to bring them into line.
What is worth noting is how deflationary the entire economy looked not all that long ago. What is also worth noting is how we are still lower than pre-crisis 2006 level of inflation worries. Now there is a lot of debate about how much of that moment where inflation hit near zero was a result of imperfect markets and illiquidity events on the TIPS market. There’s a moment in 12/2008 where the TIPS market was predicting 7 years of deflation, which seemed highly suspect. That’s a good question, and I think it won’t be easy to get a straight answer in the middle of a crisis right there. I’m more comfortable with where it is now reflecting its true market value.
Convexity and Prepayments
We are also at a point of maximum negative convexity:
we are at the point of maximum negative convexity at the moment (Figure 2). We estimate that 30-year agency passthrough universe will extend by $149 billion 10-year Treasury equivalents for a 25bps backup (parallel shift) in rates. Note that the change in duration of the 30-year passthrough universe for a 25 bps change in interest rates is a lot higher than that of corresponding MSRs, but only a small portion of negative convexity risk in agency passthroughs is actively hedged (only about 10%-15% of the risk) while almost all the negative convexity risk in MSRs is hedged fairly actively.
Self-Evident.org has an excellent “Bond Crash/Course”, designed to bring people up to speed to be able to handle reading across the curve, and I’m enjoying it greatly. If you are trying to learn what the hell bond-traders are talking about, I highly recommend it. I’m relearning it as well.
A quick way of thinking of this is that we are seeing second-order effects in the market last week. Not the actual information, but people who need to readjust to that information. Specifically people who have to hedge the negative convexity of prepayments in their MBS portfolios (to really understand the MBS and subprime crisis you need to understand how it is in part a method controlling prepayments, something that worried bond traders more than the defaults did in the salad days).
I’ve been worried time to time about how well the option ARMs are going to perform over the next two years. My worry has been lessened due to the 30-years trading so low that re-financing, the whole point of consumers having the option ARMs, was still on the table. That’s gone. Disappeared. 2 weeks a 25% jump. It’s like a game of musical chairs, and the music has stopped. There’s no cramdown legislation on the horizon either – the banking industry has wiped that. We are going to go into mid-teens U3 numbers and low 30s U6 with the housing sector the way it is right now.