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Fixed Income with Harley Bassman

Insight in Volatile Markets

While equity investors look to the VIX index as a measure of volatility, the real source of terror is in the bond market. The MOVE Index, which measures bond market volatility, hit the 160s in March 2020 - up over four standard deviations from its post-2012 average. ICE Data Services head of indices Phil Galdi spoke with MOVE index creator Harley Bassman.

Phil Galdi:

Can you talk about the distinction between bond and equity market volatility, and why it's so important to pay attention to what's going on with bonds?

Harley Bassman:

The MOVE and the VIX are very similar in that they basically measure short dated one month volatility. The key thing is that these indices are mostly coincident indicators as opposed to forward looking, because they tend to track realized volatility. There's a very tight correlation between the realized movement, the day to day market activity of liquid instruments, and options on them.

Why the MOVE was so valuable recently is that, while the VIX and equity markets get all the headlines; the bond bucket is actually much bigger, and it tends to signal things ahead of the equity market, because the underlying plumbing of finance happens in the bond market. Although the VIX went up a lot, the MOVE went up awful a lot more - and that really told you that this was a serious problem in the market, because bonds should not move more than stocks do.

Phil Galdi:

So when you hit times of stress, do the two indicators tell you different things about the market? I look at that portion of the chart centered around the '08 crisis, and right in the middle there a lot of similarity, but before and after there are some pretty notable deviations.

Harley Bassman:

There are three main risks in the financial markets. You have duration risk, which is often measured by the yield curve. That's like, "When am I going to get my money back?" You have credit risk, which is "If I get it back", and then you have the path dependent convexity risk which is, how you get it back. All three of those tend to move somewhat in tandem. I would never advise anyone to go and trade the MOVE versus the VIX. They will go together up and down over time, but the timing and the sizing are such that it would be, well, problematic to try to trade them together. As this chart shows you, in the big picture, they move in tandem together as risk moves between the various sectors of finance.

Phil Galdi:

Let's focus in on duration risk. You have already said that the MOVE is not a leading indicator of the direction of interest rates", and if so what do you focus on when looking at vol metrics? What are the key signals, and how do you leverage them in your work?

Harley Bassman:

This goes back 25 odd years. This is the yield curve as measured by the two year versus the 10 year swap rate. They generally go hand in hand, because to the extent you have shape in the yield curve, very steep or very inverted, either one's fine, volatility rises with it. When you have a very steep curve, so a two year of, call it two, and a 10 year of four, that creates a forward rate that's much higher than today.

When we get that, the steeper the curve or the more inverted, the bigger the distance between today's interest rates and tomorrow’s interest rate. Time only goes one way. So the future becomes the present, which means that forward rate got to come to the spot, today's price, or today's spot price has to go up to the future price. The bigger the distance, the bigger the spread, the more movement there has to be, and therefore the more uncertainty you have; and the price of uncertainty is implied volatility. That's the same for the VIX as for the MOVE.

Now on this slide, you can see that this idea we were surprised by this move in the market is preposterous.

There was a bell ringing over here in the bond market last year. You see that last summer, you had a huge move in interest rates. The 10 year rate went from two and a half to one and a half over the course of a few months. If you look at the MOVE, that ball jumped by about 30% over that same period. That's a pretty big move in a happy market with low VIX, with high stock prices, that's a big move.

And that was your signal that there's something wrong. The MOVE gave you that signal that under the water, call it an iceberg, there is activity going on that is problematic and troublesome.

Phil Galdi:

I've heard many people talking over the past few weeks about the fact that this crisis is really very, very different from 2008, but I also couldn't help but notice that for about four weeks - Feb 20 to March 23 - the downturn in the high grade and high yield corporate indices was almost identical to their respective moves in the weeks immediately following the Lehman bankruptcy in 2008. The two trajectories have since diverged as the credit markets rebounded strongly at the end of March. The high yield index is up about 1% on the day so far. That all followed the massive injection of stimulus from the Fed, but the tracking over that four week period was noteworthy. You mentioned a connection between volatility and credit. Talk about that, and how has that relationship behaved over time.

Harley Bassman:

Here you have a comparison between rate volatility, the MOVE, and credit spreads. You can see they go hand in hand. The issue here, which is becoming problematic, is the Fed came in and saved the day. We're not quite sure of the fundamental problems in the market. We're going to find those out in the next six months, but the Fed has stopped the panic.

What concerns me right now about trying to use the MOVE as a helpful coincident indicator for what's going to happen in credit going forward is that if you believed in the zero boundary condition, which is that rates in the US can't go negative, I think you'd have people in the streets with pitch forks going up Broad Street for the Fed. The Fed is basically doing some yield curve control right now to keep the curve relatively flat by buying assets.

So, this is not surprising at all that we've seen the MOVE get cut by half to a third recently. We had a signal last summer when rates went down. The next big signal is going to be when the MOVE ticks up again. That's going to happen when people think that the backend is going to rise either because the Fed releases it, because the Treasury Department is issuing so much debt to cover the deficit, or because there's going to be inflation. Any of those reasons that can have the back end of the curve rise, and move away from zero.

And so, I think the MOVE is going to be your best predictor for risk. That may take a few years for this to happen, but the MOVE is going to be your best indicator out there when people start to go and spend money to buy rate protection, because they think the curve is probably going to move because the Fed will have lost control or will at least be releasing control of the back end of the curve.

Phil Galdi:

So in your mind, the next signal to watch for is when the MOVE starts going up again. Are you talking about another spike such as we saw during March or more a gradual type of increase such as we saw in one of your earlier charts that was occurring back in 2019?

Harley Bassman:

I think it will be more like 2019. I mean, you could see the MOVE jump back up again easily right now. I'm thinking more that, when we come out of this thing before the next big event the MOVE will stabilize, and then we'll get a larger MOVE again. I think that is going to be predictive. Right now, despite the fact the equity and credit markets rallied so much, we're still in the middle of this thing. The Fed and the government has been very helpful in cushioning, but we're not sure what the end game is yet, and I think the MOVE is a signaling that the Treasury market is finding its level. I would be surprised to see a huge upward move in rates from here.

Phil Galdi:

Where do you think the 10 year Treasury will be one year from now? What does all of this suggest to you as far as the future direction of interest rates one year out?

Harley Bassman:

I would direct people to my website convexitymaven.com, and there I've stated that the 10 year rate would not go above 3.5% in the next five years. I think the driving demographics is the labor force growth rate that drives inflation, and drives interest rates. It's really a matter of what the Fed wants to do, but I don't see inflation or labor force growth demographics driving rates higher for 3-5 years.

Phil Galdi:

How would you hedge a rate sensitive portfolio in the current environment? Linear, options or no hedge at all.

Harley Bassman:

I think sharpe ratios are an advertising tool, and not a risk management tool. Sharpe ratios are very deceptive in what they do, and sharpe ratios encourage leverage, which is really a bad idea. When things go haywire, leverage is what kills you, which is what's happened to most of these investment vehicles. My preferred risk management tool is sizing of the individual investment. Tail hedge funds. Clearly those things look like they've done very well, and they have. It's unclear to me that those things are winners over the course of a decade, because the price of those options are extraordinarily high relative to the probability of them happening.

I suspect that a lot of the tail hedge funds have written guidelines on how to manage that. They'll say every time the option goes from 10 delta to a 25 delta, they sell it and roll it down. So, they capture some of the money, and they use those profits to buy a new hedge. Something like that has to be occurring unless you're just an incredible trader. If you're that good trader, why are you buying options? Just go and sell your assets. Buying short dated puts, I think those are fine, but you have to have a plan about when to cash them and when to use them because it is very challenging. My preferred risk management tool is sizing. I buy an asset large enough so it makes a difference in my portfolio, but small enough so I can survive a draw down, and that's been my idea.