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Beware of a Very Aggressive Steepening of the Yield Curve by the Fed

Looking past tomorrow, what should everyone expect from the Fed?
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Jack Farley interview two genuine bond gurus, image from video clip.

Jack Farley interview two genuine bond gurus, image from video clip.

Here's a very interesting interview of Joseph Wang and Harvey Bassman by Jack Farley.

  • Wang was a senior Fed trader, trading the Fed's QE program
  • Bassman was on the opposite end. He invented the MOVE index,  a volatility measure for bonds similar to the VIX index for stocks. 

The Bond Market Has Spoken

Benefits of a Steeper Curve

At roughly the 28 minute mark Bassman commented on the benefits of a steeper yield curve, citing banking, insurance, and a transfer of income from capital to people.

To paraphrase Bassman in my words, zero percent interest on savings with inflation running 7.9% is very regressive on savers. 

"Should the Fed want to engineer a steeper curve?"  Bassman asked Wang.

Aggressive Quantitative Tightening (QT) Coming?

Wang replied with a set of statements that caught my ear. I immediately paused the video to write down Wang's response: 

  • "I am thinking they will actually take your advice. tomorrow. 
  • "I am getting a sense there will be a very aggressive steepening of the curve engineered by the Fed by very aggressive quantitative tightening." 
  • "You have housing going up 20 percent, that's not normal right? A lot of people cannot afford homes any more. 
  • "The way that you touch housing is not by hiking the Fed Funds Rate. People do not borrow mortgages at the overnight rate. 
  •  My guess is that if you do aggressive enough QT that it will bleed into the 10-year as well." 

Bassman to Wang

"As a boomer I suppose I should be happy because they have elevated asset prices and elevated home prices by their various policies at the expense of my four kids who have a much harder time buying a house or anything else." ...

"The Fed buying mortgages has pushed up home prices against millennials."

Fed policies have made household formation, having kids, and moving out of smaller apartments very difficult to impossible.

Forced Deleveraging and Risk Parity

At the 40:42 minute mark a statement by Bassman caught my ear.

"Right now the biggest thing to worry about is higher rates, not inflation, and lower stock prices because then what you have is risk parity people taken out in a stretcher and there will be forced deleveraging." 

That was in reference to the highly-acclaimed and widely-used 60-40 stock to bond asset allocation portfolio where both sides lose money simultaneously. 

"Will we get that now? I don't know," said Bassman answering his own question.

"When both go down, you get crazy town."

Those who are heavily leveraged are the ones who will get taken out in a stretcher, likely including pension plans. Everyone else will just have huge losses.

The 60-40 portfolio is negative for the year. This is the worst start for the 60-40 ever noted Jack Farley.

The leveraged "risk parity" funds are now 70% stocks and 130% bonds. Ouch!

FANG Stocks are Like 70-Year Bonds 

The 48-minute mark by Bassman is also interesting, 

"There are a lot of equities out there that are kind of like bond proxies.  Your FANG stocks are basically 70-year duration bonds," said Bassman.

The reason these stocks behave like long-term bonds is the alleged cash returned to investors will be well into the future, if ever. 

But assume the story is true and these companies will eventually have huge profits. How much will money be worth a decade from now at high inflation?

Forward Rates

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At the 52 to 55 minute mark Bassman debunks those who place undue emphasis on predictability of the forward curves.

"A forward rate is a mathematical discounting of the spot curve. It's not a prediction.

Inverted forward curves do not have the predictive power of a current inversion.

Products Based on Daily Changes

Unless you are into very short-term timing and can do it well, I concur with Bassman "Do not touch the daily change products. Go away."

"All the daily change products are a slow grind down to zero."

Dovish, Hawkish, or Very Hawkish?

Farley to Wang Q: Will the FOMC meeting be Dovish, Hawkish, or Very Hawkish?

Wang A: I think it will be very hawkish. and I think we are at an inflection point on how monetary policy is being conducted, not just at the Fed but throughout the world. We are headed into a world where rates are going higher. And it will be hugely disruptive.

Mish Comments


Thanks to Joseph Wang, Harley Bassman, and moderator Jack Farley for a very important and timely discussion.

The one fly in the aggressive ointment idea is a pair of questions:

1. Why did the Fed take so long to taper?

2. What history does any Fed since Volcker have other than backing down at the first sign of any trouble?

Regardless, even a normal cycle can crush equities.

What if Wang is Correct?

We are all guessing. I am sure we will see points of view tomorrow in every direction.

But opinions, mine included are cheap. However, I want to add an important idea.

IF Wang is correct then Bassman will be correct on this: "Right now the biggest thing to worry about is higher rates, not inflation, and lower stock prices because then what you have is risk parity people taken out in a stretcher and there will be forced deleveraging."

Stocks and bonds will both get hammered. That especially applied to the FANG stocks that act like long-duration bonds.

Most People Have No Idea How Much Stocks are Likely to Crash 

Repeating myself one more time, Most People Have No Idea How Much Stocks are Likely to Crash

Wang is of the view whatever it takes to cool inflation. And that take to me means demand destruction caused by higher mortgage rates and a collapsing stock market.

If so, today's stock market rally will quickly unwind, perhaps by the end of the day tomorrow. 

Regardless, a crash will soon resume if Wang is correct. A 60-40 portfolio will not be a place to hide. 

This post originated at MishTalk.Com.

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