Using the Yield Curve to Forecast Volatility
Skin In The Game
Featuring Harley Bassman and Michael Green
Published on: June 18th, 2019 • Duration: 58 minutes
Harley Bassman, founder of The Convexity Maven and inventor of the MOVE Index, sits down with Mike Green of Thiel Macro to talk volatility, MMT, and Bassman’s strategy for structuring his trades. In this no-holds-barred interview, Bassman also speaks to several indicators he’s using to determine when the volatility tide will turn. Filmed on May 22, 2019 at the EQDerivatives conference in Las Vegas.
HARLEY BASSMAN: The grand scheme of the world is number of people, population, labor force, times hours worked, times productivity. And what you've seen happening over the last 10 years is a declining growth rate in the labor force, driven by demographics.
Everybody acts rationally from their own point of view. And it's management's job, the Fed's job, government's job to go and create the carrots so people act in the way that's best public policy. So, you can lay a good portion of this problem at the Fed.
At the time, we had a big skew in puts versus calls going out 10 years. And you could put together a rather fancy trade where you could buy the call, sell the put for zero cost and have incredible exposure.
The exact ticket that we looked at back then was buying the 1800 call and selling the 850 put on the S&P. Market then was about 14, 14.50 for 10 years, zero cost.
MIKE GREEN: So, I'm here in Las Vegas at the EQ Derivatives Conference again, sitting down with Harley Bassman, one of my favorite people. Harley, we are going to talk, revisiting a little bit of last year, talk about some of your recent ideas that you've put forward, you have taken a bit of a retirement but are continuing to trade on your personal account, is that right?
HARLEY BASSMAN: A hedge fund of one.
MIKE GREEN: A hedge fund of one. And that is actually a fascinating situation Because for the first time, you're not worried about what anyone else is doing, or one of the first times you're not worried about anything else is doing. And the character of your trades, I have seen them stretched in durations. I have a couple of them on. And hopefully we'll talk a little bit about them. But welcome, and let's get started.
HARLEY BASSMAN: Thank you.
MIKE GREEN: You sent us a slide package. And we're going to show a couple of these slides as we go through this. But one in particular I want to focus on is the dynamics of the relationship between equities and interest rates, 10 Year bonds in particular. When we look at this, we see that the correlation between the two has changed. And so, most people think about it as a discounting mechanism. But it now appears that higher interest rates are correlated with higher equity prices. Why is this? What does this mean to you?
HARLEY BASSMAN: Well, since the financial crisis, what we've seen is basically stocks and bonds move in opposite directions. They're basically self- hedging, which I guess is good if you're an asset manager, risk parity has been a fabulous trade. I think that if and when you see this correlation reversed, that'll be problematic. It hasn't happened yet. It looks to be correlated or most linked to interest rate levels. And so, I suspect once you get rates above 3.5% of the 10 Year, you'll probably see that equation flipped around. So, people who are hedging equities with bonds- well, they'll be sorry, because both will go down. And if you look at the last x number of years, both stocks and bonds have basically gone through their all-time highs.
MIKE GREEN: And so, when I think about this, like why would I care? I build a portfolio on 50-50 equities and bonds, somewhat independent, but ultimately, bonds are delivering me a fixed income component and the equities are delivering me whatever they're going to. Why does that correlation matter? What does that actually mean?
HARLEY BASSMAN: Well, if you're at a 60-40 portfolio, all is fine. It goes up and down and your diversified net works. So, what happens in practice is people usually lever these trades up so they might have- if they have $100, they might do $130 in bonds and $70 in equities so they've $200 totally invested. Only 100 in capital. And so, if they booked them at the same time, that's problematic, obviously.
MIKE GREEN: Well, and so this negative correlation that you're describing, the positive correlation between yield and equity price or negative between the bond price and equity price, what you're saying is, is that they dampen each other basically?
HARLEY BASSMAN: Probably, yeah.
MIKE GREEN: So, the current construction is a portfolio that is constructed at 50-50 bonds or equities might actually have far less risk than I'm targeting. But the risk that is realized in the portfolio in terms of the volatility of the portfolio, as we measure it, that's going to be much lower than the historical levels because of this inverse relationship?
HARLEY BASSMAN: Certainly. If you look back historically, really far back before '08, the cost was zero. And so, once again, it tends to be leveraged, it tends to the degree that I'm doing.
MIKE GREEN: Well, the leverage is what magnifies it. So, given this observed correlation, we double our positions, we own 100% equities, 100% bonds for a 200% levered portfolio. And if that correlation disappears, then that portfolio becomes wildly more volatile than we're expecting.
HARLEY BASSMAN: Exactly. Well, theory wherever if you have leverage, you could lose all your money or more whereas if you're not on levered mean lose everything. But that's still reasonable, you're not going to debt.
MIKE GREEN: Do you think this contributed- this phenomenon contributed to the fourth quarter of last year? You think this played a role?
HARLEY BASSMAN: It worked out very helpfully because bonds rallied, and stocks went down. So, people who were in a levered mixed portfolio, didn't like it but they did okay. The hedge worked very well.
MIKE GREEN: I think that's actually one of the important things about the fourth quarter is, is that because that hedge worked so well, there was actually a significantly greater buying power than people might have otherwise anticipated. The pensions were the huge players in this, but they needed to rebalance out of equity position- or out of bond positions that have appreciated significantly. And that created significant amount of buying power for the equities.
HARLEY BASSMAN: That, but also, there's buying and selling going on, you have sell both. If you had a different correlation of both assets went down, then there'd be no buying at all, everyone be selling everything. I think that's the key thing there.
MIKE GREEN: Well, and that underlying dynamic, I think you're right, has underpinned the growth of risk parity, the growth of these levered portfolios. And when you do that, you expand the overall demand for financial assets in total. And the only solution to that is either you issue more, or they go up in price. That's the only way you accommodate it.
HARLEY BASSMAN: Seemingly.
MIKE GREEN: What could cause that to unwind? And you highlight higher interest rates, that seems like a call that people have been making for a very long time.
HARLEY BASSMAN: I'm not predicting higher rates, my prediction, for the record, has been 10s will be below 3.5% 'til 2023 or it will be beyond there, which I think we're going to talk about probably pretty soon. But if you got rates up there, that usually would be inflation, which once again, I'm not predicting to happen anytime soon. And it seems to be inflation that seems to link up pretty well with the correlation.
MIKE GREEN: So, when you talk about 2023, let's hit on that for a second. Why particularly 2023? What do you see happening in 2023?
HARLEY BASSMAN: The grand scheme of the world is number of people, population, labor force, times hours worked, times productivity. And what you've seen happening over the last 10 years is a declining growth rate in labor force, driven by demographics. The boomers are still retiring, and the millennials are still in college. They haven't quite come into labor force, which you're going to see happening starting in 23 to 27 is a flattening and then a reversal of labor force growth rate and will start to rise significantly in probably 26 to 28. And that will help the economy and that will also probably work where you see inflation come in, as well as seeing rates going higher.
MIKE GREEN: So, when you highlight that, what we're really seeing there is primarily the last of the boomers leaving more than the millennials coming in, because the millennials are largely in, right? What you're describing is the retirement of the boomers effectively pushing out-
HARLEY BASSMAN: Both. Millennials, they're coming in, but they have to go and form families. Millennials form families probably six years later than the previous generation. And you go look at New York or San Fran, first child comes in age what- 31, 32. So, we've had delayed marriage, late families. Once you get married, have a hustle formation, buy more cars, buy more house, you buy dishwashers and beds and everything else. There's a demand for products there. This is very similar to the '70s. The inflation then was driven by this giant baby boomer generation that's paying the Python moving on through.
MIKE GREEN: Well, and the key difference, I would argue between now and the 1970s, is that the millennials are nowhere near as large relative to the group that preceded them as the boomers were. So, the boomers were explosively larger than the two generations that came before them. And it was compounded by immigration and everything else, right?
HARLEY BASSMAN: Yeah. Certainly. You'll have an increase, it just won't be as great. You won't get four [inaudible] long bonds. We're at two and a half now. So, could they go to four or five? Yeah, probably.
MIKE GREEN: There is room between those two.
HARLEY BASSMAN: A little bit.
MIKE GREEN: All right. So, given that type of forecast that you think we're three to five years away from the idea that interest rates could begin to rise significantly, what else is that? What are the trades are created? If you're able to take a sidestep and say, I don't need to decide what's going to happen over the next 12 months or even three months or one month as many managers are evaluated. How do you think about trades that might work over a longer time period?
HARLEY BASSMAN: I think you have to go look for trades where there is some regulation or politics, forces things to be out of line. I think straight up six month, investing liquid assets could be very challenging. I think that's why you've seen a hedge funds that's so underperformed. I think people are focused on Sharpe ratios are going to underperform for the same reason. You have to go longer term to go fight some of those things. And they'll be volatile. I think in the next few years, the guys who are long vol will probably be disappointed, because I don't think the curve's going to steepen until a year, year and a half from now.
I am a believer that the curve is predictive. I'm definitely in the camp that it's never different this time. The curve first inverted last December. 18 months ahead is June of next year, okay, fine, we get a recession, or something happens then. I've got my target. So, I've been advocating to buy yield curve options. They are a little richer now. I don't want to be first to advertise them, but it's still a good idea, vols are still very low.
MIKE GREEN: And when you talk about buying yield curve options, I just want to be clear, you're talking about buying bets on, say, 10s, 2s steepener, right. So, the difference between a 10 Year and a 2 Year or 10 Year and a 3 Month or anything in a forward component.
HARLEY BASSMAN: It's unfortunate, but these trades are only available professionally. Because you can't buy a call on the 2 Year or a put on a 10 Year. That doesn't work. You want to isolate that curve, whether it's up or down, and you can only get that vector risk with it.
MIKE GREEN: And so, when you're saying up or down, what you're referring to is whether yields are higher or lower, you just want to capture the difference between the two, right?
HARLEY BASSMAN: I'd be betting that you keep the 2 Year rate lower, the 10 Year rate higher. And I'm not sure which one it's going to be.
MIKE GREEN: Right. What's your bias?
HARLEY BASSMAN: Probably 2s is lower.
MIKE GREEN: Yeah. That's mine too.
HARLEY BASSMAN: In the near term, because I've already said 10s can't go above three and a half 'til five years from now. So, I'm boxed into 2s down.
MIKE GREEN: Right. One of the ways to express- if your bias towards 2s is lower, one of the ways it would be just a buy a shorter duration bonds, like you would generally view 2s as a reasonable trade at this point, that's similar to expressing some of them.
HARLEY BASSMAN: You're locking in your rate the next two years, that's good. But if you're actually right and rates go down, you're not going to make any money because there's no duration to them. So, as an asset to own to fund other activities, 2s are fine.
MIKE GREEN: And this is one of the things that is really hard for people to typically grasp is this dynamic of how curve structure actually matters in terms of the return profile. So, one of the things I sent you before we went into this, and I don't think you actually had a chance to review it, is actually the Fed coming out and talking, revealing in their minutes, that the staff has presented their ideas about how to handle any forward theory or any behavior in terms of the need to buy bonds in the future. And one of the things that they brought up is this idea that they want to skew towards the front of the curve to reestablish term premium, meaning 10s go up relative to 2s. So, that would work brilliantly in your trade. But what do you think about the implications of something like that?
HARLEY BASSMAN: Well, public policy standpoint, I think it's a fine idea. I think that governments releasing the back-end of the curve so there's information available in the market is important to people. People should know how we view it, we being the market, we being citizenry, risk in the future. In that way, we could properly go and allocate risk. When the Fed went in and did the slow rise of rates in '04 to '06, I think that was a huge contributor to the problem, because if you're raising rates by quarter point every meeting, you get more hazard I think by releasing the back-end.
And it's unclear to me that the back-end is going to go up a lot if they'd buy the front-end. Maybe it will, maybe it won't, but at least we'll know that it's the markets signaling. And I think having that signaling is important.
MIKE GREEN: One of the risks in that that I would say is that if you saw that type of behavior, it would result in an extraneous shift in the back-end of the curve that might have nothing to do with underlying risk exposures. And so, that correlation that you are highlighting strikes me that the risk would be that that would break.
HARLEY BASSMAN: Unclear to me that you're going to see back-end rates go up even if the Fed works on the front-end only. You have this baby boom demographic that needs to go and sell equity and buy debt. And that's what they've been doing for the last 10 years. I think the net buyer, retail buyer of equities is like the zero last 10 years. And it's been all on the back-end. And theoretically, you're supposed to own your age in bonds. And the average boomer is what- I don't know, 62 right now. 63. They need to keep selling equity and buying debt, and they may be able to absorb all the available supply that's out there.
MIKE GREEN: Yeah, that's going to be the real question, is when do they begin to significantly start selling their equity? Because I think you're right, I think the number is only very modestly negative at this point. But last year, we started to see it pick up fairly significantly.
HARLEY BASSMAN: You and I and Chris Cole all agree that basically, the net buyer of equity has been corporations. That's it.
MIKE GREEN: So, talk about that for a second. How do you think about the implications of corporate share buybacks as it relates to risk as you see it. And in particular, you highlighted to me one of the areas in BBBs, where there has been an extraordinary increase in the quantity of bonds, investment grade bonds, that are rated BBB. Has that been driven by the financial engineering dynamic of corporate share buybacks? And what risks does that create because that seems like one of the areas you've been very focused on?
HARLEY BASSMAN: Management 101 is just put the carrot where you want people to go and people tend to follow the carrot as directed. The Fed wanted inflation. That was the idea that- they've been talking 10 years ago, they want inflation because inflation is the way you basically get rid of debt one way or the other. They got inflation unfortunately, wasn't in wages, it was in assets. They took rates down. And people started buying equities or other high yield instruments to go in and get a return because they've removed any return in your basic safe assets, Treasuries, swaps, futures, Fannie and Freddie, any mortgages, and corporations that basically follow the line.
They can go and issue debt at very low rates, maybe even below their