Is The Fed Short Volatility? (Or Is Jerome Powell Actually Thurston Powell III?)

This is a syndicated repost courtesy of Confounded Interest – Online Course Notes for Financial Markets. To view original, click here. Reposted with permission.

The Federal Reserve doesn’t actively manage its interest rate exposure on its over $4 trillion balance sheet. Yet it purchases and sells Treasury Notes/Bonds and Agency Mortgage-backed Securities (AgMBS) in a measured way to impact interest rates.

Chris Whalen has a nice writeup on Fed Chair (to be) Jermore Powell’s thoughts on expanding and then shrinking the balance sheet.

[W]hen it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position.

we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.

I hope Powell’s messaging skills have improved since 2012 when he uttered these words. He does sound more like billionaire Thurston Howell III than a future Fed Chair.

Yes, The Federal Reserve can manipulate interest rates through its policies and INFLUENCE the volatility and duration of Treasuries and Agency MBS. (He should have made that clear, particularly for Agency MBS).

Here is a chart of U.S. JP Morgan Treasury Investor Sentiment Active Client Net Long positions are The Fed has been SLOWLY unwinding its Treasury Note/Bond portfolio over the past year. Notice that net long sentiment is in negative territory.


For Treasury shorts, the investor sentiment has been rising with the slight T-note/bond unwind.jpmsohr.png

10-year Treasury Note volatility remains repressed despite the teeny sales of The Fed’s balance sheet.


It really does look like The Fed is scared to actually try to unwind its balance sheet, particularly for Agency MBS extention risk where duration (risk) rises with rate increases. Particularly since we are in a low rate environment where small rate increases can crush note/bond/MBS prices.

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Here is a photo of the next Fed Chair, Jerome Powell.


When do we start calling Powell “The Skipper”? And who gets to be Vice Chair “Gilligan”?


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