MacroVoices #393 Harley Bassman: Convexity Spells Opportunity

Episode Summary

Executive Summary: Macro Voices 393 centered on Harley Bassman’s case that the yield-curve inversion creates unusually attractive convexity trades, especially newly issued mortgage-backed securities and callable munis. He argued inflation is structurally sticky due to debt, demographics, and immigration, while Patrick and Eric added that oil remains in a bullish trend but is due a pullback, and broad hedging/volatility appears unusually cheap despite seasonal risk.

Main Topics: Convexity as the best risk-adjusted opportunity (Priority: 5/5): Bassman argued that, given current pricing, investors are being overpaid to sell optionality and should prefer convexity exposure over duration or credit risk. He framed mortgages and callable munis as the cleanest ways to benefit from curve normalization. Inflation is structural, not just transitory (Priority: 5/5): He contended the post-GFC policy response deliberately inflated assets, and recent fiscal stimulus finally drove wage inflation. He sees demographics and immigration as key reasons inflation stays above target. Yield curve inversion and forward rates (Priority: 5/5): A major section explained that forward rates are mathematical outputs of the yield curve, not pure forecasts, yet current inversion implies market pricing for either persistent high rates or a recessionary crash. Bassman does not believe a large near-term rate collapse is likely. Mortgage-backed securities and callable munis as preferred trades (Priority: 5/5): Bassman said newly issued MBS priced near par offer the best setup because their embedded call options are rich and the market is pricing extreme convexity value. He plans an ETF strategy to isolate these securities. Credit spreads are not compensating investors enough (Priority: 4/5): He noted investment-grade and high-yield spreads are near average, despite the Fed's tightening and looming refinancing pressure, so he sees little reason to take credit risk at current pricing. Equity, oil, gold, and volatility post-game views (Priority: 4/5): Patrick and Eric discussed oil’s strong uptrend but near-term overbought condition, equity market resilience despite bear narratives, gold’s weakness amid dollar strength, and historically cheap hedges/volatility across several asset classes. Simplify and ETF structure innovation (Priority: 3/5): Bassman described Simplify’s business model as using derivatives inside ETFs to give retail/civilian investors professional-grade exposures and highlighted prior successful strategies built from options and Treasury structures.

Key Arguments: The Fed’s post-2008 response aimed to inflate away debt; in Bassman’s view, that policy succeeded mainly in inflating assets first and then wages later. Inflation is likely to remain above the Fed’s 2% target because boomers continue to retire early, millennials are entering household formation, and immigration supports labor supply and growth. The yield curve inversion does not guarantee imminent recession; forward rates are simply arbitrage-free calculations that embed probabilities of stable rates versus crisis scenarios. Duration is unattractive because long bonds have suffered equity-like drawdowns, and investors are not paid enough for that risk. Credit risk is only average-priced even though tighter financial conditions and refinancing pressures should eventually hurt lower-quality issuers. Convexity is currently the best-paid risk vector because implied volatility in rates is elevated, making optionality expensive and therefore attractive to sell. Newly issued mortgage bonds near par are superior to the broader mortgage index because they contain much richer embedded optionality and shorter effective duration. A curve steepening would mechanically reduce option values on callable structures, benefiting mortgage and muni holders even without a big move in Treasury yields. Broad equity and commodity hedging appears cheap relative to seasonal and macro uncertainty, but the driver is often funding/forward-price mechanics rather than complacency. Simplify’s ETF strategy aims to package these institutional trades for ordinary investors using derivatives rather than only cash bonds.

Data Points: Macro Voices episode: 393 - Feature interview and market discussion Release date: September 14, 2023 - Episode production date S&P 500 December futures: 4517 - Up 103 bps week over week as of Sept. 13, 2023 U.S. dollar index: 104.80 - Down 9 bps, near 2023 highs WTI crude oil (Oct.): 88.52 - Up 153 bps, continuing bullish trend Gold (Dec.): 1933 - Down 57 bps, sluggish price action Copper: 379 - Flat on the week, middle of four-month range Uranium: 62.40 - Up 163 bps, at 2023 high 10-year Treasury yield: 4.25% - Down 3 bps, still near 2022/2023 highs EIA crude inventory: +4.0 million barrels - Versus consensus expectation of -2.0 million barrels Cushing crude inventory: -2.5 million barrels - Notable drawdown at key physical hub Gasoline inventory: +5.6 million barrels - Much larger than expected build Distillate inventory: +2.6 million barrels - Much larger than expected build U.S. oil production: 12.9 million barrels/day - Up 100,000 barrels/day, nearing all-time highs Mortgage spread: ~180 bps over the 10-year Treasury - Bassman called it near financial-crisis levels for non-credit mortgage convexity Mortgage current coupon: ~5.5% coupon / ~97-98 price - Bassman’s preferred newly issued mortgage bonds Mortgage index price: ~85 - Older 3% coupon mortgages dominate the index Mortgage index yield/duration: ~3.5% yield / ~10-year duration - Illustrates why the broad index is less attractive Simplify AUM: $2.5 billion - Bassman described firm growth and ETF strategy Option strategy return: +92% last year; +14% YTD - He cited prior Simplify strategy performance Out-of-the-money S&P 500 put price: As cheap as ever - Patrick highlighted historically low hedge costs VIX: Multi-year lows - Equity volatility remained subdued Oil volatility index: Multi-year lows - Despite strong crude rally, optionality remained cheap Gold volatility index: Multi-year lows - Gold optionality also inexpensive Non-financial corporate net interest costs: Lowest in 60 years - Patrick noted lagged impact of Fed hikes on corporate costs

Pivotal Quotes: "Why take credit risk when the market is paying traders who understand convexity more handsomely?" — Harley Bassman: Core thesis of the interview and the rationale for favoring convexity trades "I think the market is actually saying ... there's a 85, 90% chance rates stay here, and there's a 10 to 15% chance that rates go to 1% because we go into some car crash and recession." — Harley Bassman: His interpretation of negative forward-rate pricing "You will get ... a distribution yield of about 5.3, 5.4 ... It's just the pink line." — Harley Bassman: Description of the new ETF strategy targeting newly issued mortgage bonds

Implications: Bassman’s framework favors mortgage and callable-structure exposure over duration or credit, while Patrick’s charts suggest hedges are unusually cheap and oil remains constructive. Listeners should watch curve steepening, refinancing pressure, and delayed corporate stress into 2024.