MacroVoices #393 Harley Bassman: Convexity Spells Opportunity
Harley Bassman discusses how the Fed's inverted yield curve creates opportunities in convexity trades, particularly mortgage bonds, while arguing that inflation will persist due to demographic factors and debt dynamics rather than being transitory.
Summary
In this MacroVoices episode, Harley Bassman explains his view that inflation was intentionally created by the Fed as a feature, not a bug, to reduce debt-to-GDP ratios through asset price inflation rather than wage inflation. He argues that persistent inflation will continue due to demographic trends - baby boomers retiring early (enabled by Fed-inflated asset wealth) creating labor supply constraints, while millennials entering peak household formation years drive demand. Bassman breaks down bond investing into three risk vectors: duration, credit, and convexity, arguing that current market conditions make convexity the most attractive. He demonstrates how the inverted yield curve creates mispricing in options markets, making mortgage bonds particularly compelling. These securities trade at financial crisis-level spreads despite having no credit risk, purely due to their embedded optionality being overpriced. Bassman explains the mathematical relationship between forward rates and option pricing, showing how a normalization of the yield curve would benefit callable securities like mortgages and municipal bonds. He advocates buying newly-issued mortgage bonds trading near par with 5.5% coupons rather than the broader mortgage index, which consists mainly of low-coupon bonds from previous years trading at steep discounts. Bassman also addresses misconceptions about equity hedges appearing 'cheap,' explaining this is purely a function of the inverted yield curve affecting forward pricing rather than actual reduced hedging costs. He announces his firm Simplify Asset Management is creating a new ETF strategy to capture these mortgage bond opportunities, taking advantage of recent regulatory changes allowing more sophisticated derivative instruments in ETF structures.
About this episode
MacroVoices Erik Townsend and Patrick Ceresna welcome Convexity Maven Harley Bassman to the show. Harley says why take credit risk when the market is paying traders who understand convexity more handsomely. They also discuss inflation and the other usual macro suspects. https://bit.ly/3ZeEsmF Download Harley's charts: https://bit.ly/45TT516 Check out Energy Transition Crisis on YouTube: https://www.youtube.com/@EnergyTransitionCrisis1 Download Big Picture Trading chartbook 📈📉 https://bit.ly/3sRkWAq ✅Sign up for a FREE 14-day trial at Big Picture Trading: https://bit.ly/2JjZR7J Please visit our website https://www.macrovoices.com to register your free account to gain access to supporting materials
Key Insights
- Bassman argues the Fed intentionally created inflation to reduce debt-to-GDP ratios, choosing inflation over growth as their solution to the post-2008 debt crisis
- He contends that asset inflation rather than wage inflation was the primary result of Fed policy for the past decade, contributing to wealth inequality and political problems
- Bassman identifies baby boomer early retirement as a key factor constraining labor supply, enabled by Fed-inflated asset values giving them sufficient wealth to quit working
- He explains that millennial household formation at age 31-34 is driving increased demand for housing, cars, and consumer goods, creating persistent inflationary pressure
- Bassman argues immigration is crucial for economic growth, stating that choking off immigration reduces overall economic output regardless of other policy considerations
- He demonstrates that mortgage bonds are trading at financial crisis-level spreads (175+ basis points over Treasuries) despite having no credit risk, purely due to embedded optionality mispricing
- Bassman shows how the inverted yield curve creates mathematical distortions in forward rates, with markets implying Fed rate cuts of 100+ basis points that he believes won't materialize
- He explains that newly-issued mortgage bonds with 5.5% coupons trading near par offer superior risk-return profiles compared to the broader mortgage index dominated by low-coupon discount bonds
- Bassman argues that apparent 'cheap' equity hedges are actually a mathematical artifact of the inverted yield curve affecting futures pricing rather than genuine reduced hedging costs
- He contends that current market conditions favor selling volatility (convexity) over taking duration or credit risk, as implied volatility is trading well above historical averages
- Bassman predicts that yield curve normalization will drive significant price appreciation in callable securities like mortgages and municipal bonds through reduced embedded option values
- He announces Simplify Asset Management is launching a new ETF strategy to capture mortgage bond opportunities, enabled by recent regulatory changes allowing more derivative instruments in ETF structures
Topics
Transcript
Thank you. Eric Townsend and Patrick Ceresna. Macrovoices episode 393 was produced on September 14th, 2023. I'm Eric Townsend. Convexity maven Harley Bassman returns as this week's feature interview guest. Harley says, why take credit risk when the market is paying traders who understand convexity more handsomely? We'll also discuss inflation and the other usual macro suspects. And I'm pleased to finally announce the release of Energy Transition Crisis, my new docuseries explaining why climate change isn't even the best reason that we need to break our addiction to fossil fuels. You can watch it for free right now on YouTube or at energytransitioncrisis.org. There's also a link in your Research Roundup email. And I'd consider it a personal favor…
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