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The guest commentary below was written by Harley Bassman (aka Convexity Maven) Managing Partner at Simplify. This piece does not necessarily reflect the opinions of Hedgeye. |
This is a quick off-cycle Comment to explain what is happening to the Yield Curve.
Indeed the FED has been slow in shutting down the money printing; and the market is anticipating a quickening of policy that may well lead to a recession sometime in the summer of 2023, but that does not explain the extreme volatility in the bond market, usually a bastion for safety.
Over the years, Wall Street devised Structured Notes to offer civilian investors a way to earn an above market yield, without any credit risk.
These Notes, issued by the To Big To Fail banks, might offer an 8% yield for a year, and then pay 5-times the spread between the 2-year rate and the 30-rate. So if that spread was 150bp, a level it was at just last year, the Note would kick off a coupon of 7.50%. (Well above the Junk Bond yield of ~5%.)
This Structured Note would also have a "zero-strike floor", so if this spread ever went negative, the client would NOT owe Wall Street any money.
Wall Street dealers would hedge this risk via various means, but this included being short this "zero-strike option", which I will tell you is tremendously hard to manage.
When the 2s vs 30s spread approached zero in February, Wall Street dealers went into panic mode as they were Short Convexity on the Curve via this option; to hedge this risk, they quickly started selling 2yr bonds and buying 30yr bonds. And as you know, each time they did this, the Negative Convexity made it worse.
Below is the Actual Volatility of the 2s vs 30s Yield Curve spread.
A similar occurrence happened in 2008, which I detailed here.
What is important to note, is that unless these Structured Notes mature (or are called), this option is still in the market, and if the Yield Curve starts to flatten such that the 2s vs 30s spread again approaches zero, it will be as violent in the other direction.
