Talking Convexity, Interest Rates and the Future of Inflation with Harley Bassman

Episode Summary

Executive Summary: Harley Bassman explains convexity as the core lens for valuing bonds, options, and ETF portfolios, and argues Simplify’s products use derivatives to improve return profiles and add protection. He also argues inflation is stickier than markets expect, the Fed is late but justified in tightening, and higher rates are undermining the traditional 60/40 portfolio while making mortgage bonds and mortgage REITs more attractive.

Main Topics: Convexity as the foundation of investing (Priority: 5/5): Bassman defines convexity in plain terms as the shape of returns: linear versus non-linear payoffs, emphasizing that positive convexity offers more upside than downside and can be priced relative to benchmarks like Treasuries. Simplify ETFs and derivative-based portfolio design (Priority: 5/5): He describes Simplify’s business as packaging convexity and institutional derivative strategies into ETFs for civilians, including rate hedges, buffered equity exposure, and credit convexity trades. Sizing, diversification, and ego control (Priority: 4/5): Bassman stresses that position sizing matters more than perfect entry points, arguing investors should set hard limits, diversify, and avoid overconfidence and concentrated bets. Inflation, Fed policy, and real rates (Priority: 5/5): He argues inflation was predictable once money growth outpaced real economic growth, that current inflation is stickier than markets hope, and that the Fed must keep raising rates until real rates are positive. The changing role of the 60/40 portfolio (Priority: 4/5): Bassman says 60/40 is not dead, but the classic stock-bond diversification benefit weakens when rates rise above roughly 4%, especially when both asset classes sell off together. MOVE index, volatility, and fixed-income opportunity (Priority: 4/5): He explains the MOVE index as the bond-market analog to VIX, used to gauge rate volatility, and argues elevated bond volatility creates opportunities in long-duration convexity trades. Mortgage bonds and mortgage REIT opportunity (Priority: 5/5): Bassman outlines how mortgage bonds are priced through the Fannie/Freddie securitization chain and argues rising mortgage spreads make mortgage bonds and mortgage REITs attractive, despite their leverage and rate risk.

Key Arguments: Convexity is simply the non-linearity of returns: positive convexity means more upside than downside, and investors should pay for that profile when possible. Simplify’s strategy is to embed convexity and institutional derivative structures into ETFs so ordinary investors can access professional-grade payoffs. Buying convexity can improve a portfolio when investors rebalance after the convex asset rises during market stress and then redeploy proceeds into cheaper risk assets. Sizing matters more than precision entry because investors rarely buy the exact bottom; a disciplined allocation prevents one thesis from destroying the portfolio. Inflation was always likely once money growth exceeded economic growth; the later direct transfer of money into households during COVID made inflation broad-based rather than just asset inflation. The Fed is now forced to catch up with inflation, and higher rates are necessary to restore positive real rates even if that risks recession. The 60/40 portfolio worked unusually well when stock-bond correlation was negative; that relationship weakens when rates rise above about 4% and bonds and stocks fall together. Mortgage bonds are attractive because the spread widened dramatically, and mortgage REITs offer a leveraged way to express that view, though with meaningful risk. MOVE is a useful gauge of bond volatility, analogous to VIX, but it is more a risk-allocation signal than a precise short-term trading tool.

Data Points: Simplify assets under management: over $1.5 billion - Bassman and the hosts discuss Simplify’s rapid growth and ETF lineup Company age: less than 3 years old - Host notes Simplify is still a young ETF firm Employee number at join: 9 - Bassman says he came out of retirement and joined as employee number nine Convexity example payoff: 2 gained / 1 lost - Used to illustrate positive convexity versus zero convexity Convexity example downside: 3 lost / 2 gained - Used to illustrate negative convexity Typical mortgage bond spread: about 75 bps over Treasuries - Bassman cites historical mortgage spread pricing as a benchmark Tight mortgage spread last year: 30-40 bps over Treasuries - He calls this pricing “insane” and unfavorable for buyers Recent mortgage spread: about 175 bps over Treasuries - He says this widened level created an opportunity to buy Interest-rate hedge product: 7-year option on the 3-year Treasury - Example of a Simplify convexity-based hedge product Equity buffer product: $98 in S&P 500 + $2 in puts - Illustrates a buffered equity strategy with disaster protection Fed funds target path: to 4.5% - Bassman says Powell signaled rates would likely reach this level Rate-hike pace: 15 to 20 quarters (75 bps increments) - He references the expected hiking path Inflation threshold for easing: headline CPI around 4-handle; core PCE around 2-handle - He says the Fed should wait for these levels before considering cuts MOVE index level: 150 - He cites MOVE around 150 as indicating very large rate volatility MOVE implied daily move: about 5 bps/day - Derived from annualized MOVE levels to illustrate daily bond volatility VIX example level: 30 - Used to show how annualized equity volatility translates to daily moves Rate regime threshold: above 4% - He says stock-bond correlation tends to flip around this level Risk parity leverage example: $130 bonds + $70 stocks for $100 equity - Illustrates leveraged 60/40-style portfolios Housing affordability example: $500,000 house falls to about $350,000 - He estimates the affordability impact of rates rising from roughly 3% to 6.5% Household emergency savings statistic: 40% do not have $400 - Cited as a Fed study showing consumer fragility

Pivotal Quotes: "Convex me is very simple." — Harley Bassman: He is defining convexity in an accessible way for retail listeners "Sizing is more important than entry level." — Harley Bassman: He explains why position size and discipline matter more than perfect market timing "The Fed knew they had a problem last year." — Harley Bassman: He argues policy was delayed for political reasons and now has to catch up

Implications: Investors should focus less on predicting exact turning points and more on payoffs, sizing, and diversification. Higher-for-longer rates favor convexity, hedged structures, and selectively mortgage-related assets, while making traditional stock-bond diversification less reliable.