Archive for the ‘Bond Market’ Category

Re-Blog: Limits on the 500-pound Gorilla

February 22, 2018 5 comments

With interest rates flirting with 3% on the 10-year Treasury note, and the potential (and eventuality) that they will go significantly higher, I thought it might be timely to review a blog post from February 10, 2013 called “Limits on the 500-pound Gorilla.” (It’s worth reading that original post for some of the comments attached thereto.)

Well, here’s an interesting little tidbit. (But first, a note from our sponsors: some channels didn’t pick up my article from  last Wednesday, “Fun With The CPI,” so follow that link if you’d like to read it.)

The Fed adds permanent reserves by buying securities, as we all know by now. The Open Market Desk buys securities and credits the Fed account of the selling institution. Conversely, when the Fed subtracts reserves permanently, it sells securities and debits the account of the buying institution.

As of February 6th, the Fed owned $1.782 trillion in face value of Treasury and agency mortgage-backed securities. At the closing prices from Friday, those securities are worth $2.069 trillion, plus accrued interest which I didn’t bother to calculate.

So let’s revisit for a second the question of how the Fed would unwind the quantitative easing and actually tighten policy. In order to do that, the Fed would first need to vaporize the $1.58 trillion that exists in excess reserves, before they could actually affect the required reserves which is where the rubber meets the road for monetary policy (at least, in the absence of the “portfolio balance channel”).

We have reviewed some of the options before: sell the securities held in the System Open Market Account (SOMA); conduct massive and long-dated repo operations; sell bills or pay interest on deposits at the Fed (or raise IOER). Some people have suggested that the Fed could just “let the securities in the SOMA roll off”: i.e., let the bonds mature and don’t reinvest the proceeds. I was curious how long, after Operation Twist, such a passive approach would take.

The current value of Excess Reserves is $1.58 trillion. If Excess Reserves did not move for any other reason, it would take until November of 2039 before we saw that many bonds mature. To be fair, with coupon payments and such it would take less time, but we’re still looking at a couple of decades. So that’s not an option, at least by itself.

Then I noticed something interesting. Some economists have suggested that when the economy begins to improve, the Desk could simply start selling securities into the market, since with a stronger economy the Treasury would presumably be running a smaller deficit (now, that’s blind faith if ever there was such a thing) and auctioning fewer securities, so the Fed could take up the slack without impacting the market very much. Leaving aside the question that it isn’t clear that market rates would be in the range they are now if the Fed actually stopped buying (after all, that’s the whole point of the portfolio balance channel – that investors won’t pay the high price the Fed has set so they buy riskier securities), I’m not sure it’s even possible that the Fed could drain the excess reserves even if they sold every single bond on their balance sheet. Here’s why.

The SOMA portfolio has a DV01 of approximately $1.56billion, based on the reported holdings and Bloomberg’s calculated modified duration. For those unfamiliar with bond math, this means that every 1/100th of 1% rise in interest rates causes the value of the Fed’s holdings to decline $1.56bln.

The current market value of the portfolio, as I said, is $2.07 trillion, while Excess Reserves are $1.58 trillion. But the problem is that the ‘market value’ of the portfolio assumes the portfolio is liquidated at mid-market prices. Ask the London Whale how well that works when you are a big player. Ask Long Term Capital.

But forget about the market impact. Suppose interest rates were to rise 300bps, so that the 10-year was around 5% and, with expected inflation remaining (again, let’s go with the blind faith argument) around 2.5%, real interest rates were up to around 2.5%. That would be a fairly neutral valuation for an economy with decent prospects and contained inflation, growing at its sustainable natural growth rate.

The SOMA portfolio, valued 300bps higher in yield, would be worth $2.07T – $1.56B * 300 = 1.60T. In other words, if the Fed sold every single bond in its portfolio, 300bps higher, it would just barely be able to drain all of the excess reserves. Yes, I did ignore the question of convexity, but since the MBS tend to have negative convexity that balances the positive convexity of the Treasuries, I suspect that isn’t a huge effect over this small a move.

So the Fed, in this circumstance, would have used all of its gunpowder just getting back to the point where traditional tools would begin to work again. This is an entirely natural outcome, by the way! If a behemoth market participant lurches into the market to buy securities, and then lurches to sell them, and repeats that pattern over and over, it loses value because it is consuming liquidity in both directions. It is going to be buying high (and again, that’s the Fed’s goal here: to pay more than anyone else wants to pay) and selling low. So in this case, if rates rise 300bps, the Fed will be unwinding its entire portfolio and have no securities left to sell to actually drain the liquidity that matters.

This is obviously a thought experiment – I can’t imagine the Fed could unwind that sort of portfolio with only a 300bp market impact. But it just highlights, for me, the fact that the ‘end game’ for the FOMC almost must involve raising the interest paid on excess reserves – the other tools aren’t only impractical in size, but may be de facto impotent (because, remember, the first thing that needs to happen is that Excess Reserves are drained, before policy has traction again through the traditional channels).

I am sure someone else has pointed out this little mathematics dilemma before, but I don’t think it had previously occurred to me. I guess I’d always stopped at the mechanics/feasibility of selling $2 trillion in securities, and never asked whether that would actually do the job. I don’t think it would! It is not actually true that a 500-lb gorilla sits “anywhere he wants,” as the old joke goes – he can’t sit anywhere that won’t hold a 500-lb gorilla.

Now, the Committee doesn’t really seem to believe in traditional monetary policy any more, so it may be that they figure the reverse of the “portfolio balance channel” effect will be good enough: raise the returns to the ‘less risky’ part of the market enough to pull capital out of the risky parts of the market. But I find it hard to convince myself that, as much as they clearly intended to push housing and equity market prices higher, they’d be willing to do the opposite. And I do believe that other stakeholders (e.g., Congress) would be less accommodating in that direction. Which brings me back again to the conclusion I keep coming to: does the Fed theoretically have the tools to reverse QE? Yes, although they have one fewer than I thought yesterday. But is it plausible that the Fed will have the will to use those tools, to the degree they’d need to be used, to reverse QE? I really don’t believe they’d be willing to crash the housing and stock markets, just to cool down inflation.

We do live in interesting times. And they will remain interesting for a long, long time.


Are Rising Yields Actually a Good Thing?

February 6, 2018 2 comments

I’ve recently been seeing a certain defense of equities that I think is interesting. It runs something like this:

The recent rise in interest rates, which helped cause the stock market swoon, is actually a good thing because interest rates are rising due to a strong economy and increasing demand for capital, which pushes up interest rates. Therefore, stocks should actually not mind the increase in interest rates because it’s an indication of a strong economy.

This is a seductive argument. It’s wrong, but it’s seductive. Not only wrong, in fact, but wrong in ways that really shouldn’t confuse any economist or strategist writing in the last twenty years.

Up until the late 1990s, we couldn’t really tell the main reason that nominal interest rates were rising or falling. For an increase in market rates there are two main potential causes: an increase in real interest rates, which can be good if that increase is being caused by an increasing demand for credit rather than by a decreasing supply, and an increase in inflation expectations, which is an unalloyed negative. But in 1995, we would have had to just guess which was causing the increase in interest rates.

But since 1997, we’ve had inflation-linked bonds, which trade on the basis of real yield. So we no longer have to guess why nominal rates are rising. We can simply look.

The chart below shows the decomposition of 10-year nominal yields since early December. The red line, which corresponds to the left scale, shows “breakevens,” or the simple difference between real yields and nominal yields; the blue line, on the right-hand scale, shows real yields. So if you combine the two lines at any point, you get nominal yields.

Real yields represent the actual supply and demand for the use of capital. That is, if I lend the government money for ten years, then in order to entice me to forego current consumption the government must promise that every year I will accumulate about 0.68% more ‘stuff.’ I can consume more in the future by not consuming as much now. To turn that into a nominal yield, I then have to add some premium to represent how much the dollars I will get back in the future, and which I will use to buy that ‘stuff’, will have declined in value. That of course is inflation expectations, and right now investors who lend to the government are using about 2.1% as their measure of the rate of deterioration of the value of the dollar.[1]

So, can we say from this chart that interest rates are mainly rising for “good” reasons? On the contrary! The increase in inflation expectations has been much steadier; only in the last month have real interest rates risen (and we don’t know, by the way, whether they’re even rising because of credit demand, rather than credit supply). Moreover – although you cannot see this from the chart, I can tell you based on proprietary Enduring Intellectual Properties research that at this level of yields, real yields are usually responsible for almost all of the increase or decrease in nominal yields.[2] So the fact that real yields are providing a little less than half of the selloff? That doesn’t support the pleasant notion of a ‘good’ bond selloff at all.

As I write this, we are approaching the equity market close. For most of the day, equities have been trading a bit above or a bit below around Monday’s closing level. While this beats the heck out of where they were trading overnight, it is a pretty feeble technical response. If you are bullish, you would like to see price reject that level as buyers flood in. But instead, there was pretty solid volume at this lower level. That is more a bearish sign than a bullish sign. However, given the large move on Friday and Monday it was unlikely that we would close near unchanged – so the last-hour move was either going to be significantly up or significantly down. Investors chose up, which is good news. But the bad news is that the end-of-day rally never took us above the bounce-high from yesterday’s last hour, and was on relatively weak volume…and I also notice that energy prices have not similarly rallied.

[1] In an article last week I explained why we tend to want to use inflation swaps rather than breakevens to measure inflation expectations, but in this case I want to have the two pieces add up to nominal Treasury yields so I am stuck with breakevens. As I noted in that article, the 2.1% understates what actual inflation expectations are for 10 years.

[2] TIPS traders would say “the yield beta between TIPS and nominals is about 1.0.”

Historical Context Regarding Market Cycles

February 5, 2018 4 comments

I really enjoy listening to financial media outlets on days like this. Six days removed from all-time highs, the equity guys – especially the strategists, who make their money on the way up – talk about “capitulation,” and how “nothing has changed,” and how people need to “invest for the long-term.” If equities have entered a bear market, they will say this all the way down.

It helps to have seen a few cycles. Consider the early-2000s bear market. In 2000, the Nasdaq crested in March. After a stomach-churning setback, it rallied back into August (the S&P actually had its highest monthly close for that cycle in August). The market then dropped again, bounced, dropped again, bounced, and so on. Every bounce on the way down, the stock market shills shrieked ‘capitulation’ and called it a buying opportunity. Eventually it was, of course. But if there is a bear market, there will be plenty of time to buy later. This was also true in ’09, which was much more of a ‘spike’ bottom but let’s face it, you had months and months to get in…except that no one wanted to get in at the time.

If it is not a bear market, then sure – it’s a buying opportunity. But what I know from watching this drama play out several times is that you cannot tell at the time whether it’s a buying opportunity, or a dead-cat bounce. It does not help at all to say “but the economy is okay.” Recalling that the Nasdaq’s peak was in March 2000: the Fed was still hiking rates in May of that year, and didn’t cut rates until 2001.  In late July 2000, GDP printed 5.2% following 4.8% in Q1. In October 2000, GDP for Q3 was reported to still be at 2.2%. Waiting for the economy to tell you that all was not well was very costly. By the time the Fed was alarmed enough to ease, in a surprise move on January 3, 2001, the S&P was down 16%. But fortunately, that ended it as stocks jumped 5% on the Fed’s move. Buy the dip!

By mid-2002, stocks were down about 50% from the high. Buying the dip was in that case precisely wrong.

Then there is the bear market of a decade ago. The October 2007 market high happened when the economy was still strong, although there were clearly underlying stresses in mortgages and mortgage banking and the Fed was already easing. Yet, on January 10, 2008, Fed Chairman Bernanke said “the Federal Reserve is not currently forecasting a recession.” On January 18, he said the economy “has a strong labor force, excellent productivity and technology, and a deep and liquid financial market that is in the process of repairing itself.” In June 2008, he said “The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.” Stocks were already down 19%. It got somewhat worse…and it didn’t take long.

So the thing to remember is this: equities do not wait for earnings to suffer, or for forecasts of earnings to suffer, or for everyone to figure out that growth is flagging, or for someone to ring a bell. By the time we know why stocks are going down, it is too late. This is why using some discipline is important – crossing the 200-day moving average, or value metrics, or whatever. Or, decide you’ll hold through the -50% moves and ignore all the volatility. Good luck…but then why are you reading market commentary?

I don’t know that stocks are going to enter a bear market. I don’t know if they’ll go down tomorrow or next week or next month. I have a pretty strong opinion about expected real returns over the next 10 years. And for that opinion to be realized, there will have to be a bear market (or two) in there somewhere. So it will not surprise me at any time if a bear market begins, especially from lofty valuation levels. But my point in this article is just to provide some historical context. And my general advice, which is not specific to any particular person reading this, is that if anyone tells you that price moves like this are ‘capitulation’ to be followed by ‘v-shaped recoveries,’ then don’t just walk away but run away. They haven’t any idea, and that advice might make you a few percent or lose you 50%.

To be sure, don’t panic and abandon whatever plan you had, simply because other people are nervous. As Frank Herbert wrote, “fear is the mind-killer. Fear is the little-death that brings total obliteration.” This is why having a plan is so important! And I also think that plans should focus on the long term, and on your personal goals, and matching your long-term investments to those goals. Rebalancing and compounding are powerful tools, as is a value ethic of buying securities that have a margin of safety.

And, of course, diversification. Bonds today did what they’re supposed to do when ‘risky assets’ take a tumble: they rallied. As I noted on Friday: “I am not saying that interest rates are going directly from 3% to 6%. Indeed, the rates/equity ecosystem is inherently self-dampening to some degree (at least, until we reach a level where we’ve exceeded the range of the spring’s elasticity!) in that if equity prices were to head very much lower, interest rates would respond under a belief that central bankers would moderate their tightening paths in the face of weak equities.” The problem with nominal bonds at this point, though, is that they’re too expensive. At these yields, there is a limit to the diversification they can provide, especially if what is going to drive the bear market in stocks is rising inflation. Bonds will diversify against the sharp selloff, but not against the inflation spiral. (I’ve said it before and I will say it again. If you haven’t read Ben Inker’s piece in the latest GMO quarterly, arguing why inflation is a bigger risk for portfolios right now than recession, do so. “What happened to inflation? And What happens if it comes back?”)

Which brings us to commodities. If the factor driving an equity bear market turns out to be inflation, then commodities should remain uncoupled from equities. For the last few days, commodity indices have declined along with equities – not nearly as much, of course, but the same sign. But if the problem is a fear of inflation then commodities should be taking the baton from stocks.

So there you go. If the problem is rising interest rates, then that is a slow-moving problem that’s self-limiting because central banks will bring rates back down if stocks decline too far. If the problem is rising inflation, then commodities + inflation bonds should beat equities+nominal bonds. Given that commodities and inflation bonds are both relatively cheaper than their counterparts, I’d rather bet that way and have some protection in both circumstances.

The Era of Bizarro Bill Gross is Beginning

February 2, 2018 2 comments

Note: my articles are now released about 8 hours earlier on the blog site and on my private Twitter feed @inflation_guyPV, which you can sign up for here, than they are released on my ‘regular’ Twitter feed.

It’s hard to believe that 10-year yields in the US have doubled in the last 18 months. It’s the last 50bps, taking us from 2.35% to 2.84% since December, that has received the most attention but 10yr Treasury rates have literally spanned the width of the nearly 40-year-old channel over that 18 months (see chart, source Bloomberg).

Such a long-term chart needs to be done in log scale, of course, because a 200bp move is more significant when rates are at 2% than when they are at 10%. I have been following this channel for literally my entire working career (more than a quarter-century now), and only once has it seriously threatened the top of that channel. Actually, that was in 2006-07, which helped precipitate the last bear market in stocks. Before that, the last serious test was at the end of 1999, which helped precipitate that bear market.

You get the idea.

The crazy technicians will note that a break above about 3.03%, in addition to penetrating this channel, would also validate a double bottom from the last five years or so. Conveniently, both patterns would project 10-year rates to, um, about 6%. But don’t worry, that would take years.

Let’s suppose it takes 10 years. And let’s suppose that velocity does what it does and follows interest rates higher. The regression below (source: Bloomberg) shows my favorite: velocity as a function of 5y Treasury rates. Rates around 5% or 6% would give you an eyeball M2 velocity of 2.1.

So, let’s go to the calculator on our website, and see what happens if money velocity goes to 2.1 over the next decade, but real growth averages a sparkling 3%.

Looking down the “2.1” column for velocity, we can see that if we want to get roughly 2% inflation – approximately what the market is assuming – then we need to have money growth of only 1% per annum for a decade. That is, the money supply needs to basically stop growing now. The only problem with that is that there are trillions in excess reserves in the banking system in the US, and trillions upon trillions more on the balance sheets of other central banks, and not only does the Fed not plan to remove all of those reserves but rather to maintain a permanently larger balance sheet, but other central banks are still pumping reserves in. So, you can see the problem. If money growth is only 3%, then you’re looking at average inflation over the next decade of 3.9% per annum. By the way, average money growth in the US since the early 1980s has been 5.9% (see chart, source Bloomberg). Moreover, it has been below 3% only during the recessions of the early 1990s and the global financial crisis, and never for more than a couple of years at a time.

The bottom line is that rising interest rates and more importantly rising money velocity create a very unfortunate backdrop for inflation, and this is what creates the trending nature of inflation and the concomitant ‘long tails’: higher rates create higher velocity, which creates higher inflation, which cause higher rates. Etc. The converse has been true for nearly 40 years – a happy 40 years for monetary policymakers. Yes, I know, there are a lot of “ifs” above. But notice what I am not saying. I am not saying that interest rates are going directly from 3% to 6%. Indeed, the rates/equity ecosystem is inherently self-dampening to some degree (at least, until we reach a level where we’ve exceeded the range of the spring’s elasticity!) in that if equity prices were to head very much lower, interest rates would respond under a belief that central bankers would moderate their tightening paths in the face of weak equities. And if interest rates were to head much higher, we would get such a response in equities that would provoke soothing tones from central bankers. So tactically, I wouldn’t expect yields to go a lot higher from here in a straight shot.

I am also not saying that money velocity is going to gap higher, and I am not saying that inflation is about to spring to 4% (in fact, just the other day I said that it will likely be mainly the optics on inflation that are bad this year because some one-off events are rolling out of the data). Just as with interest rates, this cycle will take a long time to unwind even if, as I suspect, we have finally started that unwind. We’re going to have good months and bad months in the bond market. But the general direction will be to yields that are somewhat higher in each subsequent selloff. And some Bizarro Bill Gross will be the new Bond King by riding yields higher rather than riding them lower.

I am also told that mortgage convexity risk, which in the past has taken rallies and selloffs in fixed-income and made them more extreme, is less of a problem than it used to be, since the Fed holds most mortgages and servicing rights have been sold from entities that would hedge extensions to those who “just want yield” (unclear how this latter group responds to the same yield, at longer maturities). On the other hand, the Volcker Rule has gutted a lot of the liquidity provision function on Wall Street, so if you have a million to sell you’re okay; if you have a yard (a billion) then best of luck.

I will note that real yields are still lower (10year TIPS yields 0.70%) than they reached at the highs in 2016, which were lower than they got to in 2015, which were lower than they hit in 2013. The increase in interest rates is not coming from a surge in belief about rising real growth. The increase is coming from a surge in concern about the backdrop for inflation. For nominal interest rates to go much higher, real yields will have to start contributing more to the selloff. So I think we are probably closer to the end of the bond selloff, than to the beginning…at least, this leg of it.

Velocity and Rates and the Vicious Cycle Possibility

November 1, 2017 3 comments

There was a potentially important development in inflation recently, but one that was generally overlooked.

Perhaps it was mostly overlooked because it is way too early to say that a trend is developed that could cause an adverse inflation occurrence. But I think that the main reason it was overlooked is that monetary velocity is not very well understood. In particular, most people seem to think that money velocity – definitionally, the number of times a unit of money is transacted in a year, on average – is somehow tied to nervousness about the economy. So, when money velocity fell in the global financial crisis, many observers attributed that to savers stuffing dollar bills in the proverbial mattress.

There may be some role for investor/consumer uncertainty in the modeling of velocity, but at best it is a secondary or tertiary cause. The main cause of changes in velocity is simple: when the cost of holding money is high, we work hard to hold less of it, and when the cost of holding money is low, we don’t mind holding more of it. Friedman first noticed this, so it isn’t a new discovery. In monetarist speak, velocity is the “inverse of the demand for real cash balances,” and the demand for such balances depends of course on the relative cost of cash balances relative to other investments.

The chart below shows the power of this relationship. I’m using the 5-year constant maturity treasury rate, but there are obviously other investments that would get thrown into this relationship. But it’s easy to envision the effect here. When interest rates are at 6%, then money does not sit idle for very long or accumulate without limit in your bank account – you will invest those monies in, say, a 5-year CD or Treasury Note, rather than earn basically nothing in a checking account. But when interest rates are at 1%, the urge to do so isn’t as much.

What you can see in the chart is that interest rate moves tend to precede movements in money velocity, which is what we would expect from a causal relationship such as this. So the reason that money velocity plunged in the GFC wasn’t because people were scared; it was mostly because interest rates fell, taking away the incentive to invest longer-term.

Changes in money velocity, of course, tend to cause changes in inflation. MVºPQ, after all, and Q tends to be mostly exogenously determined by aggregate fiscal variables, industrial policy (what’s that?) and the like. Changes in M and changes in V tend to be reflected mainly in P over time.

Also, interest rates are affected by inflation, or more properly by the expectations of inflation. And expectations about inflation tend to follow inflation.

So, the history of the 1980s’ declining inflation can be read like this, without too much of a stretch: declining money growth under Volcker caused declining inflation initially. The decline in inflation tended to cause interest rates to decline. Declining interest rates tended to cause declines in money velocity. Declining money velocity tended to cause declines in inflation…and we were in a virtuous cycle that extended, and extended, and extended, until we were close to zero in interest rates and inflation, and money velocity was as low as it has ever been.

Now, you can see from this chart that interest rates bottomed in 2013, but really have not appreciably risen above the lows, and so money velocity hasn’t reversed its slide although since the beginning of last year the trajectory has been slowing (I suspect some nonlinearity/stickiness of this relationship near zero). But the GDP report from last Friday, combined with recent money growth and increase in the price deflator, implied that money velocity actually rose slightly.

It has nudged higher before, but not by very much. And this is why I am reluctant to make a huge deal about this being the start of something, except that this is the first time since 2008 that there has been a reasonable expectation that interest rates might continue to rise because the central bank wishes it so.

And so I don’t think it’s wrong to consider the “what if” of the next cycle. Normalization of interest rates implies normalization of velocity, and there’s just no way to get appreciably higher velocity without higher inflation. Higher inflation would probably produce higher interest rates, because however much your expectations about inflation are “anchored” they are likely to become unanchored if inflation of 3%-4% starts to print. Higher interest rates could lead to higher velocity, and we have a cocktail for the opposite of the 1980s virtuous interest rate cycle.

This speculation isn’t destiny, and a lot depends on whether interest rates start to move higher and by how much. But there is already starting to be some concern about inflation and the FRBNY’s “Underlying Inflation Gauge” has recently gone to new post-crisis highs (see Chart above, source Bloomberg), so I don’t think it is unreasonable to consider and prepare. Because the best case for the next inflation uptick is that it rises a bit and falls back. But there are elements in place that support a much worse case, and that is a feedback loop through interest rates and velocity. The chances of that outcome are considerably higher than zero.

Note: these articles are now first released on my private Twitter feed, which you can subscribe to for only $10 per month here. Subscribers also get my real-time tweet analysis on the monthly CPI report, which are not on my public feed, and I am working on adding a free chart package to the mix as well.

Inflation-Linked Bonds: For the Wary, but the “Wise?”

Only a quick article at the moment. This is longer than a tweet-length answer, but didn’t need to be super long.

A friend sent me the link to the following article from the FT:

Will UK inflation-linked bonds be the choice of the wise?

I must confess I don’t know about the answer to that question, although it is true that UK linkers – especially long linkers – are perennially rich thanks to pension fund demand. Below is a chart (source: Enduring Investments) that shows our analytical rich/cheap series for 10-year UK linkers.

But the article also includes a common gripe about inflation-linked bonds that isn’t really fair, and should be addressed. The argument is that inflation-linked bonds don’t really protect against inflation, because changes in real yields are much more impactful to the return than are changes in inflation.

This is true. It is also true that changes in nominal yields are much more impactful to the return of nominal bonds than is the coupon rate or yield on the bond. If you buy a 10-year Treasury yielding, say, 3%, and hold it for two years, you will most likely get a return quite a bit different from 3% because changes in the yield-to-maturity over that period overwhelms the yield of the bond (especially now). You only get 3% if you hold to maturity. (Well, technically you get 3% if you hold for a period equal to the Macaulay duration, but that’s a discussion for another time.)

So it isn’t fair to criticize inflation-linked bonds for not being an inflation hedge over every time period. As with nominal bonds, they are a perfect inflation hedge if held to the proper horizon, and a less-than-perfect hedge over different time periods.

However, you shouldn’t be trying to hedge inflation over the next week or month. You should be trying to hedge inflation over the long term. Accordingly, the fact that returns vary due to changes in real yields is not a damning fact about linkers. Unless, of course, you’re a highly levered participant.

Categories: Bond Market, Quick One, Theory, TIPS, UK

Inflation Trading is Not for the Weak

June 27, 2017 1 comment

I was prepared today to write a column about horse racing and value investing…that will have to wait until tomorrow…when this article was sent to me by about a dozen people:

Deutsche Bank Said to Face Possible $60 Million Derivative Loss

The article was sent my way because the loss was tied to a trade that used US dollar inflation derivatives, and since that’s a market I basically started back in 2003 folks figured I might want to know. And I do.

The inflation derivatives market is not huge. The chart below shows rolling 12-month inflation derivative volumes (source: BGC Partners) through last September, which was the last time I went looking for the data for a presentation. Total interbank volumes are around $10-15bln per month; customer volumes are not included here but are not insignificant (any more).

Most inflation books, especially these Volcker Rule days, are run pretty close to the vest. Most of these volumes will be set against customer flows, or against bond breakevens, or against other positions on the inflation curve. Net risk positions for any derivative book, especially these days, are pretty small…which is why Deutsche is investigating whether risk limits were breached in this case. In principle this should be easy to figure out, since DB and every other bank has risk control specialists whose job it is to monitor these risks.

But inflation risks are complex. Our firm breaks fixed-income risks down into six basis risks that add up to the net risk of a bond. For a TIPS bond, there is just one risk; for a corporate bond there will be six. Our risk schematic starts from real rate risks and builds up – unlike in most risk systems, which start with nominal risks and try to force real bonds to fit. Inflation-linked derivatives also have commodity deltas implied, since they are tied to headline inflation and headline inflation is tied largely to energy prices. Geez, I could write a book on this – it would be a combination of “Inflation Risks and Products[1] and, in this case, “Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports.”

Suffice it to say that even really sharp investors don’t always quite get it when it comes to inflation. In early 2014, a prestigious investment management firm took a multi-billion-dollar bath on a “risk-parity” product that hadn’t truly understood how to figure out the risks of TIPS. How much more difficult, then, is it for risk control officers, many of whom have shiny new Ph.D.s and very little direct market experience? A fast-talking trader who knows something about the product can, if he is unscrupulous, persuade risk control that he is not really taking risks that he knows, or ought to know, he is taking.

In short, I am sympathetic with the risk control guys in this case. They were probably outgunned by a slick operator pushing the limits of his limits. It’s almost assuredly the case: the market, as large as it is, is too small in the Volcker Rule era to allow the accumulation of a prudent position of large enough size to cause this sort of loss – especially in the recent period of exceptionally low market volatility.

This, then, is an object lesson: if you’re running inflation risk, and you think it’s pretty much like running nominal rate risk – you’re wrong, and you should get help before your firm’s name is the one in the Bloomberg article.[2]

Tomorrow, we can talk about horse racing.

[1] In which I co-wrote a chapter, on commodities actually, with Bob Greer.

[2] To be fair, in this case the problem was the combination of ignorance and what appears to be malfeasance. If you’re careful with your control structures and only hire high-quality people of sterling reputation, you shouldn’t have a problem with the second part of this formula.

Categories: Bond Market, TIPS, Trading
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