Mark Twain reportedly once said, “History doesn’t repeat itself, but it rhymes.” There was an observation this week that US Treasury notes and bonds are trading in their tightest ranges since 2006. Do you remember 2006? Part-time bartenders and dead people were getting $500,000 mortgages with a “piggy back second” on vacation homes. Good times!
I was working at a big Wall Street bank, and my market was Agency (Fannie Mae, Freddie Mac, and Ginnnie Mae) Mortgage-Backed Securities (MBS). Agency MBS is all about interest rate duration and option volatility. In 2006, my Agency MBS brethren and I were considered dinosaurs on Wall Street. The real action was going on in the non-agency MBS arena. Remember all of these great products and acronyms: Subprime, Alt-A, Option ARM, CDO, CDO Squared, SIVs, etc. If you weren’t buying, selling, or making $800 million AAA-rated securities out of $1 billion D-rated loans every week, you were sent off to the corner to play with your “ancient” investment products.
In 2006, the yields on Agency MBS were relatively very low, and volatility in interest rates was practically non-existent. A lot of big money managers and hedge funds were selling volatility (selling options for a premium) to “enhance” these low yields. Essentially, it was a big bet that rate volatility was going to stay torpid for a very long time. As 2006 rolled on, the big funds kept selling volatility as seemingly everyone that mattered, including the Fed, was blissfully unaware that the fuse had already been lit on the greatest financial bomb since The Great Depression.
In fact, 10 years ago, Federal Reserve Chairman, Ben Bernanke, spoke from Jackson Hole just like Chairwoman Janet Yellen spoke from there today. The subject of Chairman Bernanke’s talk was “Global Economic Integration: What’s New and What’s Not?” A read of Mr. Bernanke’s speech shows that he knew that the globe was indeed “integrated,” just not like he thought. It was integrated on the hope that the bartender could make five monthly mortgage payments on his five investment properties! We all know how that worked out.
The frightening thing is, 10 years later, no one is blissfully unaware of all the badness that is swirling around the global financial landscape. At least they shouldn’t be. Yet, the trading strategy from major money managers is the same as 2006. They are selling volatility with both hands and both feet! I would even argue that the flow of funds that keeps pushing stocks to new highs is little more than a bet against volatility. The best managers in the world, like Jeff Gundlach, have been saying the upside for stocks is miniscule compared to the downside. That sounds a lot like the asymmetric profile of selling an option (selling volatility), doesn’t it?
The theme of my last few posts has been the factors that are exposing the financial markets, and hence the global economy, to a sequel of The Global Financial Crisis of 2007–2009. Very large segments of the investment universe being on the wrong side of volatility when volatility returns is another very dangerous development. Prepare accordingly.
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