Treasury Liquidity Freakout: Searching for a Market-Maker

As someone old enough to have done finance in the Paleolithic pre-personal computer era (yes, I did financial analysis using a calculator and green accountant’s ledger paper as a newbie associate at Goldman), investor expectations that market liquidity should ever and always be there seem bizarre, as well as ahistorical. Yet over the past month or two, there has been an unseemly amount of hand-wringing about liquidity in the bond market, both corporate bonds, and today, in a Financial Times story we’ll use as a point of departure, Treasuries.

These concerns appear to be prompted by worries about what happens if (as in when) bond investors get freaked out by the Fed finally signaling it is really, no really, now serious about tightening and many rush for the exits at once. The taper tantrum of summer 2013 was a not-pretty early warning and the central bank quickly lost nerve. The worry is that there might be other complicating events, like geopolitical concerns, that will impede the Fed’s efforts at soothing rattled nerves, or worse, that the bond market will gap down before the Fed can intercede (as if investors have a right to orderly price moves!).

Let’s provide some context to make sense of these pleas for ever-on liquidity.

Believe it or not, capital markets did a perfectly fine job of providing funding for companies without having perma-liquidity. For instance, it was generally understood in the stone ages of my youth that equity markets were receptive to dodgy wares like technology IPOs only two or three years out of every five, and even then, the issuer better have six quarters of earnings. Yet that period of not very good IPO access was one of the most stellar periods for the establishment of computer hardware and software giants: Lotus, Microsoft, Apple, Cisco, Sun, Oracle. In other words, entrepreneurs may have been BETTER motivated to build lasting enterprises by focusing on the business of the business and not fixating on The Great IPO Exit, which would eventually be there for them as long as they kept their venture growing and profitable.

Similarly, back in the days of stone knives and bearskins of the 1980s, individual corporate bond issues were understood not to be all that liquid, but buyers didn’t seem terribly bothered. If you really did need liquidity, you’d stick with the issues that were well-traded, such as AT&T or big utility bonds. But corporate bond buyers could get adequate pricing even if their particular bond wasn’t heavily traded because corporate bond prices were easy to grid: dealers and investors could extrapolate pretty well from the liquid issues, adjusting for the feature of each deal (ratings, maturity, coupon, sinking fund, call protection. For lower rated issues, you might have to look into the covenants). And remember, an investor expected to get a little yield premium for taking an issue that was less liquid. After all, everything in finance can be solved by price.

In the intervening years, we’ve had persistent efforts both by regulators and from industry participants themselves for more liquidity. And it’s not hard to make a case that the push for extra liquidity has gone well beyond the point of optimal value, at least as far as having capital markets provide benefits for society is concerned. Various studies have concluded that high frequency trading in stocks is detrimental, in that it adds liquidity when no one needs it, as in when liquidity is already ample, and drains it when it is most needed, when markets are roiled. And this means equity market structures, despite the appearance of greater ease of transactions. As former derivatives trader Craig Heimark and we wrote in April:

Perversely, much of the regulation of the last twenty years has been nominally in the interest of “market efficiency” but has come at the expense of market integrity. Far too many of the arguments and studies saying the promotion of competition among exchanges (and dark pools) has led to greater efficiency look at the efficiency as measured by the bid ask spread (plus fees) only of trading in the top stocks (because if they are trade weighted so that is where all the volume is). But this greater efficiency comes at the expense of no reciprocal liquidity obligation (witness the flash crash) as well as reduced liquidity in less frequently traded stocks.

The societal benefit of trading is to reduce cost to raise capital for actual companies. Does anyone really think that narrowing the spread on Google by a penny or two makes any difference to its weighted average cost of capital? In contrast, incidents like the flash crash and the feeling the market is rigged keep many small investors away from the market. The penalty for reduced liquidity in small stocks may actually be material to small company capital formation.

And these small investors are right to be concerned. The old exchange system was a hub and spoke model, which was a stable system architecture. The internet was an outgrowth of a DARPA project to make a communication system so decentralized that it could not be taken out by a nuclear strike. Hub and spoke models are stable, but subject to an outage, say by a nuclear bomb or electrical failure. What chaos theorists have found is that highly decentralized networks are stable, as are single node networks (like exchanges), but that slightly decentralized networks are fragile. And that is what we have now thanks to the SEC’s misguided efforts to “modernize” the stock market via Regulation NMS.

So regulators have left investors with the worse possible market structure. We no longer have liquidity obligations to make orderly markets as we had with the old model. Our current system is more complex due to some decentralization, but it is not so decentralized that it is robust (in technology-speak, a synchronized mesh network). The complexity of keeping the slightly decentralized model synchronized is what makes the system unpredictable and more fragile. This is not just an academic network construct. It is why we saw some exchange crashes recently (like Nasdaq) that were due to code changes in the linkages and feeds between exchanges.

Back to the current post. For mere mortals, “reciprocal liquidity obligation” is a fancy way of saying, “no one is particularly obligated to make a market”. Recall that in the traditional stock exchange system, that fell to specialists. For bonds, that responsibility once belonged to the lead manager of a new bond issue (in fact, the money-making opportunities for them were much greater in the secondary market, since it was the lead manager who would know who held which bonds. The more you knew who owned what, the more you could suggest trades that might fit a particular investor’s portfolio needs while allowing you the trading firm to make something on the shuffling. A dominant position produced great network effects, which was the foundation of bond king Salomon Brothers’ success in its heyday).

Consistent with Heimark’s views, regulators and investors themselves have peculiarly acted as if technology, as in order-matching, could somehow substitute for market-making. It isn’t hard to imagine that there are times when lots of investors want to dump holdings for reasons good or bad (such as news, rumors, or a wave of automatic trade execution resulting from too many people using models that are too similar. The first time we saw that movie was in the 1987 stock market crash). Economist Paul Davidson observed:

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Davison discusses as some length the LPT view versus the EMT view, which lies at the foundation of the fondness for (among other things) the push for more automated trading. Davidson points out, but frankly could have said it more boldly, that EMT has a “continuous markets” assumption, that liquidity is ALWAYS there. And why is that assumption deemed to be reasonable? Because prices are assumed to reflect fundamental values, and those values can be estimated because risks can be modeled. To put this in slightly oversimplified layperson terms, people can agree on prices because there is a presumed rational basis for pricing:

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Davidson points out that the future does not confirm to nice, neat, statistically “normal” (as in “tractable” or Gaussian) risk models and forecasts. Uncertainty is far wilder and efforts to model the extremes break down. This is the critique made by Nassim Nicholas Taleb, most famously in his book The Black Swan, following the work of mathematician Benoit Mandelbrot. Davidson refers to those types of risks as “nonergodic” as in not having a propensity to self-correct. And look where understanding the true nature of market risks takes us:

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What we’ve had since the 1980s, in addition to a belief that more liquidity was ever and always better, was a policy preference in the US for moving financing for business out of banks and more and more into capital markets, out of the view that bank capital was too costly and capital markets were more efficient. And we’ve seen, stealthily and overtly, that the central bank indeed has used its liquidity muscle to backstop markets. Greenspan was widely heralded for jawboning (and more) in the 1987 crash; we’ve seen how the Fed ran to support all sorts of credit markets during the crisis. So Davidson is simply making a clear-cut statement of where we are.

But are all these markets deserving of support? And per Heimark, have we made market structures so much worse as to make them even more dependent on central banks than they need be? We have evidence of this in the Financial Times story. The focus is a mini Treasury melt-up on October 15, when the yield on the 10 year bond dropped from 2.38% to 1.86% in a bit more than an hour. The article perversely treats this as a “meltdown” when this is in fact a “gap up,” as in lower bond yields = higher prices. But only when shorts are getting killed are price increases depicted as a bad thing (click to enlarge):

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I have to confess I also find it hard to get worked up about big price swings in a trading day. Investors have become complacent about market risk thanks to the tender ministrations of central banks since the crisis; October 15 was a rude wake-up call.

The article goes on about “seven standard deviation moves” as proof that Something Went Horribly Amiss. It might be more accurate to say that these metrics illustrate the fallacy of using “normal” distributions to measure trading risk. Let us remind you how badly these models anticipated the market action during the financial crisis. As Paul De Grauwe, Leonardo Iania, and Pablo Rovira Kaltwasser pointed out in “How Abnormal Was the Stock Market in October 2008?“:

We selected the six largest daily percentage changes in the Dow Jones Industrial Average during October, and asked the question of how frequent these changes occur assuming that, as is commonly done in finance models, these events are normally distributed. The results are truly astonishing. There were two daily changes of more than 10% during the month. With a standard deviation of daily changes of 1.032% (computed over the period 1971-2008) movements of such a magnitude can occur only once every 73 to 603 trillion billion years. Since our universe, according to most physicists, exists a mere 20 billion years we, finance theorists, would have had to wait for another trillion universes before one such change could be observed. Yet it happened twice during the same month. A truly miraculous event. The other four changes during the same month of October have a somewhat higher frequency, but surely we did not expect these to happen in our lifetimes.

But sadly, that type of risk modeling been institutionalized with the widespread use of VaR, as in Value at Risk models, not just for banks’ own convenience, but for regulatory purposes.

But what is mind-boggling, given the foregoing discussion, is that supposedly savvy investors were shocked. From the Financial Times article:

One hedge fund manager recalls being bewildered by subsequent events: “What on earth was charging through the market to want volume at such a price and why, in response to that catalyst, did the electronic marketplace just take any and all liquidity away?”

Without going through the details in the article, the explanation is really simple: a huge order imbalance, in this case, more buyers than sellers, driven by a combination of “flight to safety” purchase plus technical buyers, as in shorts who’d bet that the end of QE would lead to higher interest rates (lower bond prices) not being able to take any more pain, and closing out their positions. And there was a dearth of opportunists on the other side because so much trading is now electronic. Prices moves so quickly as to outpace normal human reactions to unexpected events. This was similarly a prime driver of the 1987 crash, when order execution moved at a snail’s pace compared to today:

The head of trading at a major dealer-bank says: “Once volatility shows up, you don’t want to make a mistake in a fast market and so you always see dealers pull back from providing prices.”…

The two main electronic trading venues for US Treasuries are run by Nasdaq’s eSpeed and Icap’s BrokerTec. In recent years these platforms have opened up to a range of broker-dealers and high-frequency traders. These firms do not underwrite US Treasury debt sales and are often viewed as opportunistic – providing prices when they spot a quick profit and then retreating when trading turns tricky.

Customer orders are now transacted and almost instantaneously hedged, or offset, by computer systems – a type of automation that works well when trading is orderly but rapidly breaks down when the situation changes. At such moments, turning off the machines becomes a necessity. This contributed to the downdraft in liquidity on October 15.

“Dealer-banks don’t really position in bonds,” said one head trader at a large US bank. “They basically act as a pass-through to places like BrokerTec and eSpeed or match off their client flow. The market-makers in this new market are not obligated to be there when everyone’s selling.”

Now while this sort of thing also happened in the stone ages of my youth (the Treasury market did come close to not trading in the worst of the 1987 crash; the Fed called the Bank of Japan and basically told the BoJ to hop to it. The BoJ told Japanese banks to start buying, and they did). But generally speaking, in bad markets, rather than prices gapping down, you were simply prevented from dealing. Your friendly bond dealer wouldn’t pick up the phone, unless it was Salomon or Bear, that staked its reputation on making a price even in really bad markets.

And that despite the now-widely-accepted view that investors have a right to liquidity, dealers not answering the phone during a panic actually is salutary. It’s an unofficial circuit breaker, exactly the sort of device that operates formally in stock markets when market moves during a day are deemed to be so large as to reflect panic. The circuit breaker allows the more speculative-minded buyers to assess what the hell is going on that led to the meltdown or up, and step in when markets re-open. It also gives the panicked seller time to cool off and determine if dumping investments at already stressed levels really is warranted.

At least this article does place primary blame on the increased role of high-speed trading and electronic order-matching. It also argues that regulations play a part, in that banks are no longer allowed to engage in proprietary trading. Without belaboring that issue, this is one of the few areas where using VaR as a measure of trading risk would be helpful, and allowing banks to take outsided positions on one side of a market or other to facilitate trading that they’d be required to “flatten” in a reasonable period of time (to be determined with further analysis, but the idea would be more like days, rather than much longer periods that many prop positions were built and then liquidated. As we’ve written, this was a serious flaw in Volcker Rule implementation and does warrant being revisited).

Where does this leave us? We intend to pursue this topic in future posts, but one take-away is that dealers are already petitioning the authorities informally for an intervention because they anticipate a rerun of a classic bond bear market, where investors who are long dump positions in order to stem losses (bond markets are so large that there is not remotely enough credible hedging capacity for a major player to go market neutral, let alone short. Recall Goldman which did try to get out of the way of the mortgage meltdown early, was short only in certain mortgage portfolios; it was still net long mortgage backed securities overall. And remember AIG was effectively bankrupted merely over providing hedges to one product, high grade CDOs, plus making bad subprime bets in its securities lending operation).

An exit is almost certain to be more violent if the Fed ever does tighten because at super low bond yields, a 1% interest rate increase results in vastly greater losses in principal value than if prevailing ten year bond yields were at, say, 4% or 5%. We think the outcome is more likely to be that the Fed is unlikely to make a serious exit of its artificially low yield posture, unless that process is extremely attenuated. But it’s not impossible, as in 1997 Japan, that the central bank comes to believe its own PR about the state of the economy and starts down the removal of low interest rate punchbowl path anyhow. And so the market nervous nellies may be proven correct, that the Fed will unleash a deluge. Whether it is just a taper tantrum redux or something more serious remains to be seen.

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  1. Ben Johannson

    Efficient markets thinking is just re-hashed Say’s Law. In fact virtually all neoclassical economics, despite the clunky, mathematically vomitous models, is an endless loop of recycling Say’s absurd notion there is only one rational way to look at money and wealth, and that everyone, everyone is equally rational. Follow the chain of logic far enough and we will invariably end up back at a “Law” that everyone other than the truly stupid knows is false.

    1. OpenThePodBayDoorsHAL

      “Liquidity freak-out”? Why we already have the central bank of a major national currency as the *only* bidder left for 100% of the debt it issues (JGB), apparently these criminals think that is somehow a normal state of affairs. They buy up the entire bid stack and stuff it in a drawer somewhere..maybe the Martian Central Bank will buy it all from them someday? Mars Attacks: ack…ack-ack-ack

  2. russell1200

    Just as a side note. The Wall Street Journal (hard copy) had a front page Finance Section story on Deutsche Bank pulling out of the CDS market and the fears of reduced liquidity there.

  3. diptherio

    Ummm…me confused:

    “Dealer-banks don’t really position in bonds,” said one head trader at a large US bank. “They basically act as a pass-through to places like BrokerTec and eSpeed or match off their client flow. The market-makers in this new market are not obligated to be there when everyone’s selling.”

    But isn’t that what makes a market-maker a market-maker? Isn’t part of being a market-maker “assuring the public that he/she will swim against any rip-tide of sell orders”? So is this unnamed trader being disingenuous, or is my definition of market-maker off? I thought that being a buyer/seller of last resort, so to speak, was the very definition of a maker-of-markets.

    1. Ben Johannson

      From the quote I would guess he’s refering to HFT as market-makers only in the sense that everyone else has to play their game. So think of him doing the quotation-mark thing with his fingers when he uses the term.

    2. Moneta

      I think you are focusing on the definition of market-maker instead of questioning why market makers are suddenly needed when that was not really an issue in the past.

    3. Yves Smith Post author

      In stock markets, in the old days, a specialist was required to “make a market”. That was his official job.

      Bonds aren’t traded on exchanges. It’s an over-the-counter market. That means if someone is to act as a market-maker, they sell into and out of their inventory.

      So you are basically right, they are being called market-makers but aren’t doing the job. They are just acting as conduits to the electronic exchanges. Narrowly, matching customer orders also is market-making, but dealers aren’t stepping up to the really important part of the job, taking one side of the trade and then selling out that position sometime later.

  4. Ignim Brites

    If equity prices were to drop 80% it would be an enormous boon for those in their 20s and 30s as they would be able to secure long term cash flows (rents if you must) at very reasonable prices. It would be such a boon it might even be considered normalising. Which leads to the consideration that the demand for liquidity, or cashification, of all assets is really a demographic phenomenon.

    1. Whine Country

      After the 80% drop those in their 20s and 30s will purchase those “rents” with what? Their youthful exuberance?

  5. Moneta

    “investor expectations that market liquidity should ever and always be there seem bizarre, as well as ahistorical”

    When yields were between 8-10%, why trade? Is anyone really committed to 30-year bonds offering 2.5%? All the signs point to pump and dump amid a sea of investors who think rates will stay low forever.

  6. weinerdog43

    “…incidents like the flash crash and the feeling the market is rigged keep many small investors away from the market….”

    I actually had to suppress a laugh at that ‘duh’ moment. Joe Sixpack and the rest of retail has long since realized that this is a crooked game. I am honestly curious if there are any NC readers that trust their brokers and are ‘fully invested’ in this market.

    1. FluffytheObeseCat

      The problem is, Joe and the rest of retail have nowhere else to park savings – except in near-negative interest rate savings vehicles. “They” don’t need to know what we are thinking. If some sea change comes along, some broadly accessible way to make a little with ones savings…… well it gets co-opted and perverted before your average schlub ever finds out about it.

      1. weinerdog43

        Yep. Although I’d probably say that when you factor in inflation, you actually do have negative interest rates, so your point is completely correct. I’m beginning to think that a nice size home safe for storing cash/currency/gold is a worthwhile investment. (Especially since I’m not going to return to the market anytime soon.)

  7. Moneta

    With the amount of bad debt issued over the last few years, we don’t need rising rates to get a default that would panic markets. All we need is the passage of time.

    How did you go bankrupt?” Two ways. Gradually, then suddenly.” ― Ernest Hemingway, The Sun Also Rises

    Tic, tic, tic….

    1. susan the other

      Sorry to speculate on a subject i do not understand very well, but it occurs to me that liquidity, even if debt is bad, can remedy even bad debt with more money and more time – and a longer mortgage. It goes against what we have always practiced and sounds crazy – but if going forward what we need in this world is stability and equality. How do we get there from here? I think flexibility is important. Otherwise how does Stanley plan to achieve “stability”?

  8. Timmy

    I think there are more loops to the repercussions of reduced liquidity than are reasonably presented in the post. First, as the liquidity issue becomes understood, game theory/talk on the street suggests “unconstrained” players will take advantage or seek to trigger liquidity breaks, which are targeted at or will come at the expense of long-only players like mutual funds or ETF’s that face retail redemptions in illiquid sub-sectors. These liquidity concerns are not well understood/managed in/across the private banks with respect to asset and fund allocations (i.e., concentrations exist). Second, the nature of the crises matters. A global macro economic or security issue is radically different than a, say, Worldcom event that raises fundamental questions about credit integrity. It is in the later case that we will need the liquidity to discriminate among risks.

    1. Yves Smith Post author

      This was already getting to be a long, and this is a post, not a PhD dissertation. I did say I’d be returning to this topic.

      However, having said that, I’m not sure I buy your thesis. We’ve had years of HFT in stocks, which are more liquid than fixed income, and this sort of gaming has yet to happen. Plus the controversial cancellation of trades in the flash crash may have the effect of killing any efforts to game. It means outcomes aren’t predictable. And the authorities are now all over Libor and FX bid rigging. Banks are being fined £2 billion for bid rigging and officials and are prosecuting some of the key actors, as well as looking to claw back comp. The downside risk of any strategy, if a firm could devise one, are a ton higher than they looked six months ago.

      1. susan the other

        I regret I didn’t understand the post – way over my head – but I do get the feeling that we need a new name for “the market”. Not to mention a good reason. I’m all in favor of a planned economy but I’d like to know where, exactly, are we going? Just today on ZH there was a blurb about Yellen holding a meeting at the NYFed with all the banksters to discuss alternatives to Libor. And she is asking them what this new rate would look like in a world of plenty of liquidity and very low interest rates.

          1. Chauncey Gardiner

            STO, speaking of ZH, your comment triggered a visit to that site. Saw this subsequent post concerning related views of a prominent and successful Scottish hedge fund manager that caused me to consider the question of whether there is some point at which central bankers will acknowledge policy failure? I mean, it’s not like they hold elective office or there is some way to quietly replace them. And anyway, what alternative policy choices would be both timely and constructive when Congress seemingly can’t bring themselves to increase domestic non-military/non-surveillance related fiscal spending programs on healthcare, infrastructure, education, etc. I really hope this all works out.


      2. Timmy

        I didn’t intend to imply that the post missed a significant issue. It was more that the loops of responses can’t be anticipated. I am suggesting, however, that performance or asset class chasing in private banks can create vulnerable concentrations of risky exposures. A large leverage loan ETF has gotten a fair amount of recent media attention for its size relative to non-crisis liquidity levels.

        My point about game theory is that players can anticipate the need for liquidity driven by retail redemptions in funds and ETF’s and either pre-position or front run the underlying securities in the early moments of a crisis. I don’t believe this is “rigging”, it is just being opportunistic but it takes advantage of asymmetric risk and liquidity conditions of funds and ETF’s and, as a result, exaggerates the impact of illiquidity.

        You are right that the outcomes are not predictable and this is a major constraint on this activity.

  9. craazyboy

    So ya telling me all dem bond traders are worried about who dey gonna sell all dem 2%, 10 year notes to and they got 10x or 30x leverage to make their yield take add up to good money in their pockets????

    Dat would worry me too, if I did something like that. hahahahaha. Hope they will give me my zero interest rate checking account money back. Otherwise I’ll have to kill myself. hahahahaha.

  10. Chauncey Gardiner

    Hugely informative post, thank you. I had not realized that liquidity concerns and a stock market “correction” on October 15th were precipitated by liquidity concerns associated with a Treasury bond buying MANIA (not a panic). At first this seemed counterintuitive to me. But on reflection, it points to price stability being key, not price direction. Why is this so?

    One possibility is that this particular set of circumstances had to do with derivatives speculations and/or carry trade positions that were adversely affected by the interplay between interest rates, currency exchange rates (especially between the Japanese Yen vs. the U.S. dollar), commodities (esp. Oil) and associated junk bonds.

    … and who are the world’s biggest speculators? (Just a thought about possibilities.)

    Repeated preemptive market involvement by the network to arrest and reverse market declines before they waterfall is also of ongoing interest. Why is this clearly now public policy and why has there been no public discussion of these hidden subsidies? “Free Markets”… Pffft!! “Free” for whom?

  11. Brian Romanchuk

    A good article. Since the only reason Treasury yields will rise is because the economy is doing well, you will not see the “bad” correlations with risk assets that corporate bonds faced in the crisis.

    But I have a minor point.

    “An exit is almost certain to be more violent if the Fed ever does tighten because at super low bond yields, a 1% interest rate increase results in vastly greater losses in principal value than if prevailing ten year bond yields were at, say, 4% or 5%.”

    A massive increase in duration will only occur for very long-dated bonds. (The worst case is for perpetual bonds – consols – where the duration is the inverse of the yield.) The duration of a 10-year note (for example) will only rise slightly (about 10% or so). A rate rise will generate losses that mirror gains that happened when rates fell; decent, but nothing to get too excited about (unless you are levered 20:1).

    1. Yves Smith Post author

      Huh? Basic bond math is that interest rate changes have a bigger price impact when yields are low. This is not about duration, it’s about losses on assets held by investors. Pull out a calculator. The sentence is correct as written. Yes, the impact is even greater with longer-duration bonds, but the sentence is correct as written.

      1. Brian Romanchuk

        What assets are you talking about? I assumed from context that you were referring to Treasury notes and bonds. Equities, being perpetuities, act like consols. But for equities, implied growth rates could rise, cancelling out the risk in the risk-free discount rate.

        Anyway, I was distracted when writing; Treasury yields will have their duration shorten during a sell off.

        A 10-year note with a 2% coupon trading at 2% (“a par coupon”) has a modified duration of about 9. Absent convexity (which reduces losses), that means its loses 9% of its value if rates rise 100 basis points. A 10-year par coupon has a duration of about 8.2, which implies a 8.2% loss for the same scenario.

        Yes, the duration (price sensitivity to yield) is higher for low yields, but the increase is not too exciting. Most fixed income investors calibrate risk in terms of the “DV01” – dollar value of a basis point. Positions will have already been adjusted for the low rate environment, and sensitivities will drop as rates rise.

        Where things get interesting is retail MBS; I never followed that market carefully, but I think the “convexity hedging” seen in previous cycles is expected to be much smaller. (The Fed will presumably not hedge its convexity.)

        1. Yves Smith Post author

          You are not disputing my point. You are arguing instead that traders are aware and prepared.

          I am pretty certain I been through more bond bear markets than you have. Your cheery assertion, “Positions will have already been adjusted for the low rate environment,” was already disproven by the taper tantrum of last year.

          As for MBS, some recognized experts in that market (as in it from its inception, have advised foreign governments, and make serious dough trading because they really understand the structures and the credits), say no one, particularly the Fed, is on top of what will happen to duration if rates go up. The assumed ~5 year duration on mortgage paper will go to 10+ years. No one will sell a house who has a cheap mortgage on it voluntarily, and people will do all sorts of creative weirdo “rent to own” deals to keep current super cheap mortgages in place.

  12. Jay M

    Mark to market. Because market, because Mark. Good looking guy, chiseled without being a chizzler. Because finesse.

  13. ChrisPacific

    The “seven standard deviations” quote by the author was irresponsible (I’m happy to see she has been taken to task for it in the comments). People should not report this kind of thing without including the real explanation (obviously bond prices don’t follow a Gaussian distribution) and debunking the facile one (Omigosh it was just such bad luck!) We should especially not accept the facile explanation from anyone who is later found to have profited handsomely from the event.

    1. Doug

      More like an assymetric Tracy-Widom distribution of correlated variables where the standard deviation scales to N^-1/6, giving a better context to these tail events that seem extreme in the Guassian frame of reference..

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