Harley Bassman, a.k.a. the Convexity Maven, is a legend among bond investors. He worked at Merrill Lynch, where he invented the MOVE Index that measures bond market volatility, and then at Pimco. Now, after a dramatic year for US Treasuries that saw investors hit with massive amounts of volatility only for the 10-year yield to basically wind up where it was at the start of 2023, he sees things starting to get a bit more normal. With the Federal Reserve getting closer to its 2% inflation target, the yield curve is going to steepen after years of intense inversion, he says. Now a managing partner at Simplify Asset Management, Bassman also talks about his favorite trades for 2024, Fed Chairman Jerome Powell's legacy, and how he chooses his famously esoteric chart colors. This transcript has been lightly edited for clarity.
Key insights from the pod:
The three buttons of bonds — 6:01
What does it mean to bet on convexity? — 10:30
Harley’s role at Simplify — 14:10
Why inflation will remain with us for a long time — 19:34
What happens to mortgage spreads now? — 22:11
How should we think of zero-day options? — 34:26
Why Harley leads to such interesting colors in his charts — 39:24
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Tracy Alloway (00:10):
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe (00:15):
And I'm Joe Weisenthal.
Tracy (00:16):
Joe, you know what one of the weirdest things about 2023 was? I guess that's an unfair question, isn't it?
Joe (00:24):
Why don't you just tell me what's on your mind? I could make many guesses, but why don't you just tell me?
Tracy (00:29):
So, after all the drama in the bond market, all the ups and downs, all the volatility, we basically ended the year kind of where we started, right around 3.8% on the 10-year yield. And I know it's picked up a little bit since then, but we basically had this really round trip. But a lot happened in between.
Joe (00:49):
That was a great choice, Tracy, for one of the weird things that happened. That was a huge story throughout the year, bond sell off higher rates, etc. And then to get to the end of December and say ‘Oh yeah, the 10-year is basically where it started the year.’ Extremely strange and unexpected. And when I saw that stat, I did not anticipate that at all.
Tracy (01:08):
Yeah. And to me, maybe this is going to be a bit of a tortured analogy, but 2023 is sort of emblematic of the bond market overall. People tend to look at it and think it's super boring. Normally — before the wild years of 2021, 2022, 2023 — it didn't move around that much. Bonds were supposed to be boring in that sense. And I think people have this view of, okay, you buy a 10-year, or maybe you buy a TIP or something like that. You invest in t-bills to get a little bit of pickup or maybe you sell some bonds. And that's basically the extent of investing in the bond market.
But there's this whole world when it comes to trading fixed income and interest rates that gets really interesting, really complicated in some ways and I feel like we don't talk about it enough. Every once in a while it hits the headlines. Like when Bill Gross was talking about selling volatility before he left Pimco. Everyone was like ‘Oh, wait a second. There's a big bond investor selling volatility. I wonder how they're actually doing that?’ But more often than not, we talk about yields, we kind of connect them to what's going on in the macroeconomy and inflation and maybe the US debt [levels], and that's it.
Joe (02:25):
No, you're totally right. There's really two things. I mean, a part of the story for bonds over the last two years was the end of this incredible 40-year bond bull market or Treasury bull market. And there were a few interruptions, of course, in ‘94, etc. and we know about that. But by and large, bonds went up yields went down, and bonds were a nice hedge against your equity portfolio and 60/40 type portfolios were great.
But then the other thing is, if you talk to an equity manager, they'll [say] ‘Oh, I like tech stocks, this year I like energy.’ Some rotation. ‘We like big caps, we like small caps, we like international.’ But it's different flavors of being long. Whereas when you look at how a lot of fixed income portfolio managers invest, as you say it is often sort of various flavors of derivatives around fixed income or spreads and things like that, rather than just sort of long here, long there.
Tracy (03:21):
Exactly. So I am very pleased to say that today we do in fact have the perfect guest to talk about the intricacies of fixed income. We have someone who actually used to work at Pimco, he's now Managing Partner at Simplify Asset Management, perhaps better known as the Convexity Maven. So we're going to be speaking to Harley Bassman. Harley, thank you so much for coming on the show!
Harley (03:46):
Thank you. Good morning.
Tracy (03:47):
Very excited to have you here. I should have added to your intro that you are also a master of colors, right?
Joe (03:54):
Which we're going to get into, the best the best color line charts in the business.
Harley (03:59):
Thank you.
Tracy (03:58):
So I have a question to begin with and this is completely out of self-interest as a journalist who's had to write about convexity at many times during their career and has always struggled to define it in a way that satisfies my editors who want to encapsulate a financial relationship in as few words as possible, how would you describe it?
Harley (04:20):
Convexity is an X word, so everyone gets a little rattled about that, but it's actually rather simple. It's just unbalanced leverage, which was also a hard concept. Let's simplify it a little bit.
If you have a bet, you're making a wager where you make a dollar or lose a dollar for equal up and down equal opposite payoffs, that's zero convexity. If you make $2 and lose one, that's positive convexity. If you could lose $3 and make $2 — negative convexity.
The reason why we hired all these PhD quants in the nineties was to basically figure out what that's worth. Clearly, you'd rather own something that makes $2 and loses $1 than is one-to-one. And if it's lose $3, make $2, you better get paid for that. And so all the mumbo jumbo we go do around pricing out these various paths and payoffs is just to make it a fair bet when you have these different payoff profiles. And that's it. Convexity just means that the payoff is not linear. It's not one-to-one.
Tracy (05:33):
Every once in a while you get to do something really great on this podcast, Joe. And asking the Convexity Maven to define convexity is one of those things.
Joe (05:31):
This was a historic moment. We're going to clip that. But let's go further down that. The most common time you hear about the phenomenon of convexity in the fixed income world is often related to mortgage-related securities. Can you then take it a step further and sort of [tell] us what does it mean? So, you describe, you know, the search for naturally occurring positive leverage in the world. Give us sort of a concrete example. Why does this pop up when we talk about mortgages frequently?
Harley (06:01):
Well, you're probably backing into the idea of are mortgages a good value right now or not? Let's just go one step back. When you're in the bond market — not equities — the bond market, you have three buttons you could push. That's it. Duration, credit, convexity. Those are your three risks.
You start with cash, overnight cash, and anything you do past there is taking one of those three. Duration is when you get your money back. Credit is if you get it back, convexity is how you get it back. And what a bond manager is trying to do is move around those three buttons to find the best risk-return, the best value.
Presently, selling convexity in the bond market is the best thing to do out there right now.
What's duration? It is when you get your money back. So a two-year security will move 1.8 points for a one point move. So if rates go from four to five, a two-year bond will move by 1.8 points. A 10-year by about eight points. A 30-year by maybe 17 points, you're usually paid more to take longer maturity risk because there's more uncertainty.
An inverted curve is kind of upside-down land because you're getting paid less to take more risk. We could talk why that is in a little bit, but right now, duration is a very weird place to take risk right now because you're paid less to go out the curve and by a 10-year versus a two-year versus overnight cash.
Credit right now, investment grade credit is trading about 57 basis points. So a little over half point over the yield curve. And you get that from looking at these interest rate derivatives on your Bloomberg, it's going to be CDX five-year. That's actually tighter, [a] smaller number than its historic average of about 65, 66. You’re paid 57 now. Junk bonds, you're paid about 360, 350, 370, which is also much tighter than usual 440, 450, 460.
So going into credit now, that's not a great bet. I mean, I wouldn't say it's a disaster, but I mean, considering we're concerned about the possibility of over tightening, a possibility of recession which an inverted curve kind of signals. I don't really want to go and take credit risk. Convexity, right now, the MOVE Index, which is a measure of the price of convexity the same way it's…
Tracy (08:22):
Which you invented, right?
Harley (08:23):
… I did. It's the VIX of bonds, plain and simple. The VIX of bonds, its average is maybe 90 or 100. It's trading 120 now, which averages out to about maybe seven, eight basis points a day of market movement. That's higher, much higher than its historical average. That's the kind of trade you want to go and do. And a mortgage security is simply a glorified buy right. That's it.
Tracy (08:47):
Wait, can I ask at a moment like this, when, as you point out, there does seem to be a lot of uncertainty, some people are still saying that there's a lot left to do when it comes to stamping out inflation, but the market is already pricing in rate cuts and some people are still worried about a recession. Is the important thing to choose which of those risks you want to take on? Duration, credit or convexity? Or is the important thing to do to identify the exact right expression of the trade?
Harley (09:18):
Well clearly, if you know where rates are going to go, you just go and buy futures contracts to call it a day. I assume that we don't know where the market will be usually. And therefore, when you're building a portfolio, what you want to do is, you're always going to have some exposure to all three of those. What you're trying to do is over or underweight these various sectors, depending upon your market view. So right now, what I'd be doing is overweighting the convexity, underweighting the credit, and then duration I'd be pulling into the five-year or earlier on the curve for a variety of reasons.
Joe (10:08):
Explain this further. When you say, okay, you want to be going long convexity, or that's where the opportunity is, because, as you say, the MOVE Index, your creation, is higher than normal, unlike say you're not getting paid for credit. How do you express that trade of going long convexity and what does that look like?
Harley (10:27):
Well actually, we’re going short convexity here. Okay.
Joe (10:28):
Short convexity. Sorry. Yeah.
Harley (10:31):
In general, I tend to be a long convexity person, and I like the idea of making two, losing one. So I've done most of my career owning convexity, owning optionality. However, as they say, no bad bonds, just bad prices. There is a level where I will sell it. And we're at that level right now.
Before the Fed came in, [and] really scrambled things up in the last decade, the old rule was, on the MOVE, you buy 80, you sell 120. The problem with that is nobody would do it. Why is that? When the MOVE got down to 70, 80, that means the market's not moving that much. And therefore, who wants to go and buy optionality? Who wants to pay time decay when the market's not moving? No one does.
So no one buys it when it's low. And when it's at 120 or higher, no one sells. You have some crazy event going on. People are hiding under their desks crying from mommy. So no one sells it at a 120. But the reality is you're supposed to go and not go naked short optionality, but you can go and just bias what you do to make yourself either short convexity or maybe it's a little less long convexity in your portfolio.
Joe (11:35):
When you say, okay, short convexity, what is the type of instrument that allows any trader or investor to express that idea?
Harley (11:43):
Well, the most simple strategy would be for an investor who owns a stock portfolio to go and sell covered calls. I mean, you're selling options. You're selling convexity when you go and you sell covered calls, what are you really doing? You're kind of converting potential capital gains to current income. You're limiting your upside. Your downside, of course is still large because the stock can go down a lot.
But you're basically kind of doing a conversion there of taking risk off the table for current income. And there's a price where you want to go and do that. And there's prices where you don't. When the VIX is at 40 or 50, I mean, you probably want to sell covered calls, of course you won't do it because you'll be in a panic. But that's kind of the idea. And theoretically portfolio managers are supposed to have no blood in their veins, and they can go and do these various trades when the time is right.
Tracy (12:31):
This is why I'm not a portfolio manager, Joe.
Joe (12:33):
Yeah, me neither.
Tracy (12:34):
Because I in fact have blood. But actually, this brings me to a question I always wanted to ask, because a lot of your trade ideas, I think they're publicly available. So like every year you publish Stocking Stuffers, which is kind of a series of trade ideas. And I'm never quite certain who those trade ideas are aimed at. And the reason I say that is because you will say stuff in them like, you know, ‘And if you don't have an ISda credit agreement, here's a way to get around that.’ But then the trade itself is still quite complicated. So I assume it's not aimed at your average retail investor. Who is the target audience for some of these things?
Harley (13:14):
Well, I'll say that as my career's gone by, I used to target high-end institutions and hedge funds. I've now moved more towards, I would call it reasonably intellectually sophisticated, high net worth retail. Is it geared towards the average person? Probably not.
But you can still take these ideas and take the flavor of them. You don't have to do the exact idea. You could just do the flavor. So if it's a duration concept, you can take your portfolio from a 10-year area to a five-year area. If it's a credit area, you could move into, you know, single A from double A, things like that. But yes, you're right. A lot of my ideas are a little tricky and entertaining, hopefully also. But yeah. It can be a challenge.
Tracy (13:57):
They are always entertaining that, that is definitely true. But, if you say something like “short convexity.” For a simplified trade, I would think do something with the MBS index. But that's not what you're advocating at all.
Harley (14:10):
Not right now. Well, my new job. I hate to give a plug over here, but I'm at Simplify Asset Management, and what we are doing is we are taking a lot of the ideas that I've had and putting them into ETFs. There was an SEC rule change a few years ago that allowed people to put derivatives, futures, options, all these various things into ETFs.
And what we've been doing is putting these derivatives into ETFs, which you could basically point and click on Robinhood. So, for instance, two and a half years ago I created an ETF where I put a seven-year put option on the 30-year Treasury, more or less, into an ETF. And this was actually, I think Bloomberg ranked as one of the highest return trades for a while.
Joe (14:56):
Is this the PFIX ETF?
Harley (14:58):
Yep. It was up 200% for a while. And it's basically a straight up way to make money if rates go up. That was it. And it was a way for civilians to get to institutional products. And I have a new product out there where it allows civilians to go and buy mortgage bonds.
Mortgage bonds, it's the second biggest asset class of bonds after Treasuries. And it's almost impossible to buy them for ordinary people for a variety of reasons. And what we've done is we have institutional quality trading abilities that we could put into ETFs. We're allowing enabling civilian investors to buy mortgage bonds that are trading near par. And right now, these par mortgage bonds trading near 98, 99, 100, are what I view to be the best fixed income investment on the planet. Right now they're trading about one and a half points over Treasuries.
Joe (15:57):
Wait, sorry. Just go. What instruments are the best fixed income investment in the planet?
Harley (16:00):
Near par — so right now, five, five and a half percent mortgage bonds.
Joe (16:06):
Okay. And how come, sorry, you were about to explain it. Why are they the best investment right now?
Harley (16:10):
Well, mortgage bonds, for all intents and purposes are US government-guaranteed. Fannie and Freddie are not guaranteed per se, Ginnie Mae are. I can assure you, Fannie Mae will never go bankrupt. If it was to go bankrupt, my advice then is to go buy cans of tuna, a gun and small denomination gold coins, because it will be the end of civilization.
So Fannie Mae's not going bust. You could buy these mortgage bonds yielding about five and a half percent right now, which I could help you go and do, which is about one and a half percent over Treasuries. Corporate bonds that can default are only 57 basis points over Treasuries. I mean, this is kind of crazy town where you could buy full faith and credit of the US government almost 1% higher than a corporate bond that can default. And if you are a believer in a hard landing, will default.
Tracy (16:58):
Wait. But the risk with the MBS, the normal MBS that you would see in the index, not the stuff that's trading really close to par that you're picking out is prepayment risk. Right? That's what you're trying to avoid?
Harley (17:11):
So I think the better question is ‘Excuse me, why are these mortgage bonds trading 1% higher than corporate bonds when clearly there are smart people in the world?’ The reason why is a mortgage bond looks and barks like a covered call, like you're selling this big call option on a 10-year Treasury. And with the MOVE at 120, that’s the way you basically do a covered call. This is the way you go and take convexity risk as opposed to credit risk.
These par mortgage bonds can be prepaid, therefore a bond trading at 99, maybe it can go to 102, 103, 104 before it gets called. That's what you're giving up when you buy a mortgage bond, is you are giving away the big upside. So if rates go from four to two, a par mortgage bond? Not going to be so good. I mean, you'll make money, you'll just make a lot less. And if rates go up, these bonds will go down like a seven-year Treasury.
Tracy (18:06):
You mentioned credit risk just then. At this point in the economic cycle, how worried are you about credit risk? Given that, you know, going into 2023, there were a lot of recession fears. There were a lot of credit experts that explicitly said they thought that defaults were going to pick up substantially. Things were going to start to fall apart in the credit market. And instead, you know, November-December, we saw a pretty big rally in the space leading to very low spreads, which you've already pointed out are kind of in crazy town territory, at least compared to some other possible investments. So how worried are you about things like defaults in 2024?
Harley (18:46):
Defaults in 2024? Not going to happen. Next year they might, when we have to refinance all the debt that was taken out. This is called the maturity wall. And there's plenty of graphs and charts about this...
Tracy (18:56):
On this podcast you have to say looming maturity wall. That's the rule.
Harley (19:00):
… Okay. Looming, yes. Well, it's looming, but it's coming. So I'm more interested in inflation than in default than in hard landing ideas. And the reason why is, I think that the demographic of these boomers retiring with a lot more money than their parents had, which means they're going to keep on spending. The old rule was when you got older and you retired, your spending was reduced because you had lower income. The boomers, well, we took all the money. Okay, I'm sorry.
Tracy (19:32):
At least you're honest about it. I appreciate that.
Harley (19:34):
We took all the money with the stocks, with the bonds, with the housing, with everything else. And so we're going to keep on spending, but we're not going to work anymore. So we're pulling out supply of labor, right? The Millennials, they're working and they're getting married and they're having kids. So they have this demand, they're going to buy stuff as they form households.
And that's what I think is going to keep inflation pressures up. The same way we had inflation in the seventies, as the boomers matured, formed households, bought cars. So I'm a believer that inflation, the 2% target is not coming anytime soon. There's a good story why it might, I'm just not a believer in that. And I also think that the Fed is not going to take rates down nearly as much as the market is implying by the futures market.
And I think that Jay Powell, good guy, bad guy, I don't know. What I know is this. He has a lot of money. He has a nice family, nice kids, probably a nice house also. What does he care about? What do we think about? Well, what is humanity all about? We still read the Greek tragedies. We still read Shakespeare. What did these guys all talk about that's still so interesting 3000 years later? Hubris. Ego. That's what drives humanity. It's always the fall of humanity. And I think what Jay Powell's thinking about now is really not inflation per se, but what's my tombstone going to say?
Tracy (20:50):
Legacy is a nicer way of saying ego.
Harley (20:53):
Is it going to be Arthur Burns, who basically is the poster child for inflation getting out of hand? Or is it going to be Paul Volcker, the saint who saved us from inflation? Some people will say it wasn't him, it was demographics, but whatever. He wants to be Volcker not Burns. And therefore he's going to go and I think hold rates up longer than people might think to go and ensure inflation is truly wooden-stake-in-the-heart dead.
Joe (21:16):
So I mean, I definitely want to get more into the maybe psychological approach to forecasting the Fed. Maybe we spend the rest of the show on that. But I do want to go back and talk the sort of boring stuff about the mechanics of mortgages real quickly.
On spreads, so the spread between a 30-year, I just did like a subtraction function, the most crude thing, but a 30-year mortgage minus 30-year Treasury a few years ago, that spread was, I don't know, around 1%, it got [t] around three and a quarter. It's come down a bit [to] 2.8. So just why are spreads as high as they are? How would you describe that gap between mortgage spreads and Treasuries right now? Why is it still at such historic highs?
Harley (21:58):
Okay. You're supposed to use the par mortgage rate on Bloomberg, MTGE FNCL, use that versus the 10-year swap rate, or the 10-year Treasury rate.
Joe (22:10):
Alright. It’s not going to be much different, right?
Harley (22:11):
You'll see about a 75, 70 basis point spread historically back 30, 40 years. it's now at 150. Why is it there? Two reasons. The easy one is vol is high. The MOVE’s at 120. That's the easy one. The harder one is that the curve's inverted. That's going to require a lot more explanation that you can go look at my commentary on my website to go read about. But those two things, the inverted yield curve and high volatility. And you're going to see when this curve steepens out, which means the two-year rate comes down below the 10-year rate, you're going to see mortgage bonds in general go up, you'll see mortgage yields come down, you'll see the retail mortgage rate come down. So that's coming. Not yet, but that's coming.
Tracy (22:54):
Wait, but one of the questions about the recent dynamic in mortgage rates is it has fallen quite quickly even though the spread between mortgages and Treasuries is quite wide. I think that's the question. It moved up really quickly in 2022, 2023 — shot above 7%, and then eventually 8%. But now it seems to be falling really quickly, even though a lot of people thought there were structural changes in the market that meant [mortgage] rates were not going to be able to come down that fast.
Harley (23:26):
Look, as I said, the mortgage bond market is the second biggest market after Treasuries. That spread of 150 drives the retail rate. And the retail rate is going to be, let's say, another three quarters to 1% over that rate. It's a business and it's a competitive business, and it kind of grinds along.
And so as you see the mortgage bonds tightened, have a smaller spread to Treasuries. You will see the retail mortgage rate come down. You're also going to see the spread between the retail rate, the rate the homeowners take versus the mortgage bond rate. That's going to compress in also for a variety of market reasons.
Tracy (24:03):
This might be a slightly unfair question, but do you have an estimate for how far the mortgage rate could come down?
Harley (24:11):
Oh yeah. I mean, eventually the Fed will cut rates and you can see an easily another a hundred basis points in mortgage rates coming.
Tracy (24:32):
I wanted to ask you about something else that you sort of threw in there. The inverted yield curve and this has been a massive topic of conversation for the past couple of years. I mean, even before the pandemic, the yield curve was inverted. And so the joke was that the Treasury market predicted Covid-19 and things like that. But when you look at the yield curve now, it's been inverted for a while. There's this big discussion over whether or not it is still valid as a recessionary indicator. What economic information, if any, are you getting out of the inverted yield curve? What does it tell you?
Harley (25:09):
If you go look at, you know, various derivatives, it indicates right now the Fed’s going to cut rates, you know, four, five, six times. So call it 120 basis points of cutting in the next year, which seems kind of crazy unless we crash market, we have a market crash.
I think what's happening is this, I don't think it's the market’s predicting that rates are going to come down by a hundred and a quarter basis points. I don't think that's it. I think what's happening here, it's like an 85% chance that rates don't move, and a 15% chance that rates go to 1%, that we have some kind of disaster. It's a bimodal. And if you add those two things together, that's how you get the down 125. No one's saying 125, I think it's zero and 400 and people are using the two-year rate or the five-year rate as an insurance policy against a bad thing happening. If you think of it in those terms, it kind of makes sense because, we only quote one number, but how do we get that number?
Joe (26:05):
Right. So the idea is if you're long risk assets, which most people are most of the time, one way to hedge that would be to sort of make big bets on rates coming down sharply. It doesn't mean that that's your main view. It just means that if your bullish view is going to go wrong, a way to hedge that is to place big bets on rates.
Harley (26:26):
Yeah, well, that's why the curve's inverted. But I mean, I think buying 10-year rates is kind of silly right now. I mean, if you're going to go and buy this theoretical insurance policy of the Fed doing a massive cut because of a hard landing, you want to buy the two-year rate and that's why we created another product that's basically a 5x levered two-year.
Joe (26:47):
Oh wow. Wait, what's the ticker on that? I want to look it up.
Harley (26:49):
TUA.
Joe (26:51):
Okay.
Harley (26:51):
In theory, civilians could do it. They can just buy their own futures contracts, but civilians usually don't have futures contracts accounts. So we offer it for them for a very small fee.
Joe (27:01):
Got it.
Tracy (27:02):
Oh TUA. I think I remember this one. I used it to compare the performance of the Treasury market to Bitcoin.
Joe (27:11):
Now I want to go look that up. Let's go back to your outlook for the year. So I really do love this sort of thinking, on his epitaph, on his obituary, Powell may have this sort of like human impulse to not be Arthur Burns 2.0. But there also is the chance for not to just avoid being Arthur Burns, but to deliver the soft landing that every economist has said [is]impossible.
So now just avoiding being one of history's sort of scapegoats, but actually being a legend and being the central banker who fought the crisis in 2020 and then delivered the soft landing when everyone said it was impossible and that we'd have to have employment go to 6% in order to get inflation down. Do you put any weight on this possibility that the FOMC goes for the ‘let's be legend’ outcome?
Harley (27:58):
Oh Sure. I think they're going to try and do it and it may well work. I'm just saying it's not going to be six cuts, it'll be two or three and it's not going to happen in March. It'll happen in July. That's all I'm saying.
Joe (28:08):
So not radically different — your sort of view of what the Fed does in 2024 is not radically different than what a lot of pundits are thinking.
Harley (28:17):
Circling back to the duration, credit, convexity idea. Duration is ‘I buy it here, it ends up there.’ Credit, ‘I buy it here. It ends up there.’ It doesn't matter how it gets to the final destination. Convexity is path dependent. It matters how you get there.
And so what we're arguing about now is not where we're going to be, but how we get there. And I'm saying that we're going to get there much slower than the market thinks, and I want to go and invest accordingly. And if I do that, this is where mortgage bonds come in.
I’ll say, if you want the big prediction, here it is. The Fed wants a 2% inflation rate. They'll get it eventually, I presume. They're going to put the funds rate at two and a half, 50 over for a 50 basis point real return. Historically, if you're a, bond geezer like I am, funds rate to two-years, 50 basis points. So now we're at three, 2s-10s, a hundred basis points. So now we're at four.
So we're kind of looking at, the 10-year right now is what? 380, 390, 404? Whatever it is. I mean, it's done. You stick a fork in it, man, the 10s aren't moving. And I think with the 30-year rate, it probably goes up from here as the curve resteepens again, all the action’s the front end, that's where all the action is going to be when it happens.
And so, the trade that the geeky quants, the complex people, as you might say, are yelling about right now is how do I go and bet on a yield curve steepening? That's very tricky to do. Fortunately I do have products that will do that also.
Tracy (29:49):
Wait, don't you just do a steepener trade? What are you recommending here?
Harley (29:54):
Sure. A steepener is exactly what you do. But who can do that? I can assure you people on this podcast can't do that.
Tracy (30:00):
Well, we can't do anything because we work at Bloomberg. To be clear.
Harley (30:03):
If you bought my PFIX ETF, that trade actually will actually make a lot of money if the yield curve steepens as I've described it, which is the 10-year not moving, the two-year coming down, the 30-year going up. That'll be a very profitable trade, if that happens. And the cost of holding that trade is rather slim for a variety of reasons that don't matter.
Tracy (30:25):
You know, one of the other things that happened in 2023 and 2022, and one of the reasons it was so painful for a lot of investors was bonds and stocks became positively correlated, right? Everything sold off all at once. And this was bad news for anyone who had constructed a 60/40 portfolio or who had bought bonds as a hedge for riskier assets. How are you viewing that relationship going into 2024? I think there's still an assumption that things are sort of moving together, but could we get a situation where maybe they become inversely correlated again?
Harley (31:01):
If you were reading my Convexity Maven commentary long enough to notice the colors I have there, you would notice that quite a number of years ago I was talking about this exact notion of the correlation of stocks to bonds. And what you saw was prior to ‘98, ‘99, 2000, you saw stocks and bonds go up and down together.
And for the last 20 years they went inverse. They were hedging each other. And now they're back to being positively correlated again. The driver of that has been the level of interest rates. And if you go to my website, I have a number of charts that show exactly this, that when inflation's below two and a half and 10-yearrates are below three and a half, you tend to see them work in opposite directions. When they're above that, they work in the same direction. So I think you're going to see stocks and bonds correlated until we get rates and inflation back down again.
Joe (31:52):
I love that. I mean, there's like an intuition if inflation is low, Fed is more on Fed put mode, etc., you sort of get this buoyancy under equities. I want to go back to the idea of the steepener. And right now, if you just were to make a chart, a dual t-axis chart, or I guess even one, two-year, 10-year yields, they kind of look the same.
But as you point out, and as people have been discussing, you could get to this point eventually where the Fed cuts and that is viewed as reflationary or, you know, creates this positive impulse and you could have the decline at the short end and then the long end as the rates go up.
When does that happen? At what point? We haven't seen it yet, right? So we've had these expectations of cuts, this pricing in of short-end cuts, and we've seen the long end go right down along with it as the two-year fell. At what point does that change such that the expectation of cuts in the short-term leads to higher rates at the long-term?
Harley (32:45):
There is the expression of don't fight the Fed. And the reason is they're bigger than you are, man. They're the casino. The Fed will cut rates. I'm not sure when, I think July, but they will cut rates and as they eventually start to cut rates, the curve will steepen out. The question is how much of this steepening will be the two-year coming down versus a rotation of twos down and 10s and 30s up? I tend to think it'll be a rotation for the reasons you've described. When it's going to happen? It's when they cut.
Joe (33:12):
So right now we have markets sort of coming down with the pricing in of cuts. But you're saying when they're actual realized cuts is when we would start to see that relationship change?
Harley (33:22):
Tracy was talking about this notion of the curve predicting the economy and it's predicted the last, I guess, eight recessions? It's been spot on for, I don't know, 40 years. We, us here, always talked 2s-10s because it's kind of fun. The actual research was the three-month rate versus the 10-year rate in Treasuries, not in swaps and the three-month rate is the Fed rate. The market can't go and pull the three-month down with the Fed rate up where it is. So you need the actual Fed to cut the interest rates to go and pull the three-month versus 10-year down. And that's when it'll happen. And all that's happening right now is people are in theory placing these bets on when this will occur. I think they're over their skis on this, but we'll see.
Tracy (34:04):
I just have a couple more questions, but one of them is slightly outside the world of fixed income. But I think given your experience in derivatives and things where the tail is sometimes wagging the dog, maybe you have an opinion on this, but, zero day options, is that something you've been following at all in the stock market?
Harley (34:26):
I find them very interesting and they're important to the extent of when these options are trading, there's a buyer, there's a seller, it's a closed system. The world has not gone more or less optional or convex. It's a closed system. However, the two parties may act differently. So once upon time, when you would see huge options selling in the bond market or option trading, that might reduce volatility, because the seller very often would be my ex-employer. And they would not be adjusting their portfolio. Whereas the buyers, people like me, when I was a trader on Wall Street, I would be delta hedging, adjusting my portfolio.
And if I'm trading against the option, but the seller isn't, that'll drive the market towards the strike at expiry. The question is now is with zero day options, are the buyers or the sellers trading them? Are they adjusting them? And I'm going to guess the retail’s probably selling the options, but in GameStop they were buying it. And so what you saw there was, GameStop they would buy the option. Citadel, Susquehanna, they would sell the option. They were hedging. Retail wasn't and that's what drove the market to be more volatile.
Right now, you probably have retail selling the options and Susequehanna buying it, and therefore that's reducing volatility. So you’ve got to figure out who's the buyer, who's the seller, who's trading it and who's not. Can we know that? I see these guys on Wall Street all the time saying, you know, ‘this is the net gamma of the world.’ Like, do I believe them? Not really. It just sells newspapers.
Joe (36:00):
Can I ask you a quick question? And I'm asking you this because you mentioned a handful of tickers that your firm Simplify Asset Management has created, like PFIX. Are these instruments that at different times you would recommend go long or short? I mean, you have this desk where you can convert institutional quality trading of futures and swaps, etc. into a retail package that one could buy even on a platform like Robinhood and when I think of asset management in general, I think of like basically managers who want to create products that will go up. But is the idea here that you want to create products that allow people to have exposure in both directions?
Harley (36:38):
Some of our products are more strategic, some are more permanent. One could argue that that PFIX was strategic when it came on two years ago, rates were at, you know, 1%, 2% and they went a lot higher, so that worked. I might add though, although the desire to buy this product is less now because clearly we're kind of in this rate paradigm of flat to lower, I'd argue that it still makes sense to own it, maybe less of it, because, you don't buy insurance because you think you're going to crash. It's because you might be wrong and you might do it.
You don't buy PFIX because you're bearish on rates. You buy it because you're bullish and might be wrong. And so as an insurance policy, a very low cost insurance policy, that makes sense. MTBA, which is our mortgage product, that's more of a lifetime product. I mean that yields 150 over the curvature. You will always have exposure in the mortgage market. If you are in fixed income, you will have some amount of money there. You should have a lot of it now in the mortgage market. And after the curve, steepens and vols come down, you should have less of it.
Tracy (37:40):
Yeah. The PFIX chart looks fantastic if you got in in 2021 and got out sort of late last year.
Joe (37:48)
October 31st, 2023?
Tracy (37:40):
Yeah, but it looks extremely painful if you got in just before the end of the year.
Harley (37:55):
We just had a huge $34 distribution.
Tracy (37:57):
Oh, is that what it is? This is my fault. I should adjust it for distributios, so I'll have to do that.
Joe (38:02):
You still didn't want to get in October 31st? The line is distorted at the end by that distribution.
Harley (38:07):
Yeah. Since the distribution, this product has been restructured to be very similar to what it was at its original entry point two and a half years ago.
Joe (38:17):
So, you kind of have to reload?
Harley (38:18):
You’re supposed to reload now. It's actually a little better product now than before. Although clearly, from 1.14 down to down to 40, it looks challenging. But remember 35 bucks of that is distribution.
Tracy (38:28):
I just have one more question. It is the most important question of this conversation.
Joe (38:32):
Are you going to steal my question?
Tracy (38:33):
Oh, yeah. Joe stole one of my questions. I don't think I am? But you can claim that I have and then show me the evidence. But this is very important. What's your favorite color? Was that your question?
Joe (38:46):
Oh! It was close. Can I just like add to the question? So for those [who’ve] never read Harley's notes, here at Bloomberg we have the gold line, sometimes a white line. I sort of leave it at that. Harley's notes — let's see, I'm looking at the most recent grab bag. There like the kituruki line, the zabibu line, the kahawia line.
Tracy (39:09):
I just like listening to Joe rattle these names off.
Joe (39:12):
And these are apparently all colors. So I was chatting with Tracy, do you like go down through like the Pantone catalog each time to come up with new [colors]. Like, what are these colors? And I guess what is your favorite? But what is all this all about?
Harley (39:24):
I started writing a commentary nearly 20 years ago. You can go to Convexitymaven.com. That's my entire inventory of commentaries. I publish every six to eight weeks. It's free. Send me an email, I'll add you to the list, I'll talk about macro concepts. I started doing colors because I hated all the charts of Merrill Lynch were all various shades of blue.
Joe (39:46):
You had to get out of that sort of strict sell-side style guides for each bank.
Harley (39:51):
And we had just created this new charting system that allowed you to actually pick all the colors available. So I started doing that just to get attention. And then after a while I started naming the colors. That was fun. That was crazy to do. And then after about, you know, 15 years, you started running out colors. So I started going to actually now foreign languages is the trick.
Joe (40:11):
Oh, got it.
Harley (40:12):
But my favorite color, that was when I used hemoglobin for red.
Tracy (40:17):
I like that. Have you considered starting your own line of paints inspired by your chart colors? Because I have to say, aspargun is a very beautiful color that I would consider for a kitchen.
Harley (40:28):
Something like that. Someday.
Tracy (40:30):
All right. A new area of diversification. Harley Bassman, that was an absolute pleasure. I'm so glad we finally had you on the podcast. We wanted to have you on for a very long time and this was the perfect time to do it. So thank you so much.
Harley (40:43):
Thank you.
Tracy (40:56):
Joe, that was really fun. I'm glad we finally had Harley on. I'm glad we got him to explain convexity to us given that a lot of his trade ideas for 2024 seem to be all about convexity.
Joe (41:08):
Yeah, no, that was a lot of fun. And I really appreciate the balance of big picture macro thinking about the reputational impulses for the Fed, the sources of inflation going forward. So these big picture macro things and then how one goes about connecting that, or as as they say in the business, expressing that in the form of very specific trades was really interesting to hear us thinking on that.
Tracy (41:31):
Yeah, and this is really what I think differentiates Harley's work from some others on Wall Street. It's the attention paid to the construction of the trade and the technicals and how exactly you are expressing a particular view. Because very often, and on this podcast included, you will have people coming on who say ‘sell credit,’ or ‘buy credit’ or whatever, but they don't actually go into how one can or do that. And it makes such a huge difference to returns and investors, ultimately. And to get back to the sort of zero day option question, it can have an impact on the overall market as well, the way these popular trades are actually constructed.
Joe (42:14):
Yeah. And as you've been talking about for a long time, really large-scale portfolio managers, it's not like stocks, not just in like even something simple about like expressing a view on rates. If you're bullish, you buy stocks, right? I mean some people might, right? But even you have some sort of view on rates like these big names, like [the] Pimcos of the world, this is what they're doing. They're coming up with different ways of expressing this that is not maybe as sort of straightforward as their peers on the equity side.
Tracy (42:46):
Absolutely. There is a whole hidden and wonderful world of total return swaps, index options or swaptions. Lots of stuff that just doesn't get as much airtime. Totally. Alright, shall we leave it there?
Joe (42:58)
Let's leave it there.