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How the Fed Saved Structured Note Issuance
There’s an aspect of the higher interest rate structure we are now blessed/cursed with that hasn’t gotten as much airplay, but which is great news for dealer desks and also a good thing for institutional investors (and some high net worth individual investors). And that is the new energy that the higher rates will inject into private note structured product.
A classic structured note is typically designed so that the buyer is guaranteed to get his money back, plus the possibility of some more-attractive payout. So, for example: I might issue a note that will pay you 60% of the total gain in the S&P 500 over the next 5 years – but if the S&P is lower in 5 years, you still get your money back. That’s a pretty simple version, but the embedded bet can be as exotic as you like (and from the standpoint of the dealer, the more exotic the better because the harder it will be for you to price it and the more profit, therefore, they can book on it).
When I was tasked with issuing notes from the Natixis Securities (North America) shelf, for example, we offered a 10-year note that redeemed at either the total rise in the CPI over those 10 years, or the average return of the S&P, Nikkei, and EuroStoxx 50, or par (100%), if both of the other two possibilities were negative. I recall another dealer in 2007 or 2008 was selling a 1-year note that had a huge coupon as long as inflation was between, say, -1% and +3%, but zero otherwise. But you still got your money back. You could structure something with knock-out options, average-price or best-of or lookback options – on interest rates, equities, commodities…even an option on a hedge fund. I want 20% of the latest global macro fund’s upside, but with guaranteed downside…
The key ingredient to all of these things, though, is interest rates – and when interest rates are very low, it is difficult to make a structured note look attractive.
Once upon a time, like back at Bankers Trust in the mid 1990s, the way a structured note was created was to make a special purpose trust that held two securities: a zero-coupon Treasury bond with a maturity equal to the note’s maturity, and ‘something else’ – usually an option. The investor would invest $100. The dealer would spend $80 on the zero coupon bond…which, since it matures at par, guarantees the principal…and have $20 left over to spend on anything else that couldn’t decline below zero. Classically, this is an option, so the trust would look like this:
Since the option can’t be worth less than zero at maturity, and the STRIPS is guaranteed to be worth $100 at maturity, this bond is principal-guaranteed by construction and has no credit risk. Any value the option has at the end of the term is an add-on. If the option is worthless, then the bond matures at par. So simple.[1]
You can see why interest rates matter. This 5-year zero-coupon bond at $80 implies that it is priced at a compounded interest rate of 4.56% (because $80 * (1+4.56%)^5 = $100). But suppose that 5 year interest rates are 0.75%, as they were two years ago at this time? Then the 5-year coupon bond will be priced at 96.33, and instead of having $20 to spend on options the structurer will have less than $4. There aren’t a lot of options priced at $4 that will be exciting enough to an investor (or have enough spread to be exciting enough to a dealer). Never mind the fact that in all of this I have neglected that a dealer generally also gets paid to underwrite and distribute the bond, so that $1 or $2 will come off the top. In this last example, the dealer doesn’t have $3.67 to spend on options…it probably has only $2. Good luck.
I present the notion behind structured product that way because it’s easy to conceptualize and because that’s the way the concept started, but it has been a long time since dealers actually used zero-coupon Treasuries in such a structure. The way such a note is made today is driven by the credit of the issuer, so the structured note trust really holds an IOU from the borrower. In most cases, this is the dealer itself but there are other companies who will issue in their name in order to get bargain financing rates (once the dealer hedges away all of their risk). The mechanics are not worth going into here: if you are someone who would care, you probably already know how to do it, and most of you won’t care. The significance is that the structurer can get a little more spread to play with, since the interest rate will be a corporate credit rather than a government bond. But still not lots.
However, now interest rates are back up. Two-year Treasuries are at 4.90%, 3-years are at 4.50% and 5-years are at 4%. That’s back to the way it used to be. Even real rates are meaningfully positive. And implied volatilities are generally low as well. All in all, structuring desks doubtless have a lot more to do these days than just a few years ago. Not everyone hates higher rates!
[1] Since this column generally concerns itself with inflation and real variables I should point out that you can also guarantee par in real terms, by substituting a TIPS STRIP or the derivative equivalent, so that the investor will get at least the inflation-adjusted amount of his money back rather than the nominal amount; however, then the structurer will have less premium to play with.
Inflation Volatility Tells Us This is Probably Not Over
In the course of this inflation cycle – and I do think this is a cycle, and not necessarily a one-off, although the subsequent peaks may not surpass this year’s peak in Median CPI for some years – the typical topic has of course been the level of inflation, and/or its acceleration or deceleration (not to mention, many uneducated suppositions about the cause, which we know good and well boils down to profligate spending and unprecedented provision of money). I’ve also written and talked about the oft-overlooked fact that when inflation rises for some time above about 2.5%-3%, stocks and bonds become correlated rather than inversely correlated, and this has a significant effect on portfolio risk that insightful investment managers will take into account.
What I haven’t written about much is the fact that problems are also caused by the volatility of inflation. While this tends to go hand-in-hand with higher inflation, the problems caused by inflation’s volatility are somewhat different than those caused by its level.
The current episode follows a 15-year period during which inflation was both low and stable. The thirty years prior to that, from 1973-2003, the level of inflation was a bit more than twice the 2004-2018 period average but the volatility of inflation was tripled.
The importance of inflation volatility is that it operates on inflation expectations in a very different way than the inflation level does. (We know that inflation expectations do not have the center-stage role in ‘anchoring inflation’ that previously-discredited theory claimed it did, but I do think there is a psychological tendency that adds some inertia to inflation by affecting businesses’ beliefs about how easy it will be to increase prices.) Inflation volatility tends to increase consumers’ perceptions of inflation through the behavioral tendencies towards loss aversion and attribution bias (as I argued in a 2012 paper published in Business Economics). But it has other effects as well.
Quantitatively, higher variance makes it harder to reject the null hypothesis that inflation is staying high; an uncertain worker is therefore less likely to accept a lower wage that may not suffice and a business is less likely to hold the line on prices that may be continuing to rise elsewhere. When you don’t know the true competitive pricing situation, both businesses and their employees are likely to err on the conservative side. This also gives momentum to inflation.
Higher inflation volatility is what causes the inflation factor to carry more weight in the minds of consumers and investors, which in turn is what induces the aforementioned positive correlation between stocks and bonds. When inflation is low (but more importantly stable), the importance of inflation to investors is also low and variations in inflation are given less weight than variations in growth. Since stocks and bonds behave similarly with respect to inflation, but inversely with respect to economic growth, the dampening of the inflation factor is the reason that stocks and bonds are inversely-correlated in low-and-stable inflation regimes.
Also, although investors seem not to incorporate this understanding into prices, higher inflation volatility should increase the value of a “tail outcome” in inflation, and increase the value of holding that option by being long breakevens, or long TIPS instead of nominal bonds. That is, when inflation isn’t going to vary too much then it’s hard to win big by owning TIPS over nominals; but if inflation varies a lot then there should be a fairly large premium built into breakevens since you’d much rather be long them (and long that tail) than short them (and short the tail). However, as I said this seems not to actually be incorporated in inflation markets, which trade far below the level they ought to if inflation tails have even a small value.
So, how volatile has inflation been?
When I started thinking about this blog post I was originally going to point out that the volatility of Used Car CPI is so much higher than it used to be. We almost never spent a lot of time thinking about how much Used Cars would add or subtract from core. Here is a chart of the rolling 12-month volatility of y/y Used Cars CPI.
Not surprisingly, the volatility of CPI for Used Cars and Trucks reached nearly double the level it did in the aftermath of the Global Financial Crisis, when the “cash for clunkers” program and the destruction wrought by Hurricane Katrina both had major impacts on the market for used cars. But it goes beyond that.
The unusual volatility of the food and beverages group, partly as a result of the war in Ukraine and the spikes in fertilizer prices, has been documented previously. It seems to be receding but remains quite high historically.
Heck, let’s look at three of my ‘Four Pieces’ (leaving aside energy). Here’s Core Goods.
Even though the level of core goods inflation has come way back down, the volatility of core goods means that consumers can’t get terribly comfortable with prices (nor can producers).
How about ‘supercore’?
This is also high, but the interesting part is how tame it had been for most of the post-GFC period. Remembering that this is the category where the wage-price feedback loop is felt most strongly, I think this says something about the flaccidity of labor power during that decade. Well, that’s back – and perhaps we’ve re-entered an extended period of volatility in that group?
Here is the volatility of Owners’ Equivalent Rent (which looks about the same as Primary Rents, for what it’s worth, so I didn’t feel I needed to show them both).
Not as terrible as I would have thought, although to be fair this is typically a less-volatile category anyway. Again, though, look at the amazingly boring period post-GFC. (As an aside, that’s when a certain inflation specialist was trying to get attention for Enduring Investments.)
In a second I’ll show all-items CPI, but first let’s look at Medical Care.
This is the only category of the ones I’ve shown where volatility is still increasing. That’s largely because of Health Insurance, which as I’ve documented/complained about for some time has endured one of the most massive swings in any imputed category. That will not plummet soon, though, since in October the Health Insurance drag of -4% or so annualized will reverse to +1% or so.
Last but not least, here is headline CPI’s volatility.
I will just say that it is a good thing that inflation dealers no longer really trade inflation options. Because, if they did, they not only would be generally short a whole lot of in-the-money inflation cap delta in the book but also would be short a bunch of vega too and implied vol would probably be a lot higher. But the importance of this picture is that while headline inflation has been receding (largely due to energy) and core inflation has been dropping too (not-insignificantly due to Health Insurance and Used Cars), the volatility of inflation does not yet look like it’s calming down in a decisive way.
Until it does, I think it would be cavalier to assume that we are heading back to the low-and-stable inflation regime, even if the last few months’ out-turns for CPI have been agreeable. Volatility, and not just the level of inflation, matters.
Summary of My Post-CPI Tweets (June 2023)
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy, but subscribers to @InflGuyPlus get the tweets in real time and a conference call wrapping it all up by about the time the stock market opens. Subscribe by going to the shop at https://inflationguy.blog/shop/ , where you can also subscribe to the Enduring Investments Quarterly Inflation Outlook. Sign up for email updates to my occasional articles here. Individual and institutional investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Check out the Inflation Guy podcast!
- Welcome to the #CPI #inflation walkup for July (June’s figure).
- At 8:30ET, when the data drops, I will run a bunch of charts. Because Twitter has made auto-posting them difficult (still not sure it’s impossible), I’ll post those charts manually with commentary as I go. Then I’ll run some other charts.
- After I’m tweeted out, I’ll have a conference call with my overall thoughts. This is usually around 9:30ish. Later, I will post a summary of these tweets at https://inflationguy.blog and then podcast a summary at inflationguy.podbean.com .
- Thanks again for subscribing!
- The forecasts this month are almost comically low. Keeping in mind that last month, core came in high at 0.44%, and hasn’t been close to 0.3% since October – my forecast is the highest except for Cleveland Fed.
- The first forecasts out of major banks were low even though they had a bump higher from Used Cars. Such a bump seems unlikely, although last month I thought would drag and it did not. But the surveys are worse this month.
- Later bank estimates penciled in declines in Used Cars that make more sense. For a while I thought I was doing something wrong.
- I’m not TOTALLY sure Used Cars will be a LARGE drag. Black Book declined in June, but it also did LAST June, and the Used Cars CPI rose. So there may be a seasonal glitch here that’s not being picked up (or is over compensated for).
- My arms-length calculation suggests an 8bp drag from a -2.4% decline in used car CPI, but I will not be surprised if it’s unchanged. I WILL be surprised at an increase.
- On the other hand, used car CPI has been running ahead of Black Book for a couple of months so perhaps that effect already happened. Thus in classic economist fashion I split the difference and penciled in a 1.2% decline, a 4bp drag on core.
- As you can see from this chart, once you make a minor volatility adjustment Black Book is a VERY good forecast of y/y used car CPI. There is volatility in the month/month (some due to seasonals) but it’s heroic to forecast a large miss.
- Now, aside from Used Cars there must be other drags to give us the lowest core CPI in a long time. The large banks are looking for another decline in airfares and a retracement of the strength in lodging away from home.
- (To be clear, I don’t usually spend much time looking at other forecasts until after I’m done with mine. But I peeked more this month because of the really low forecasts coming out).
- Basically, the Covid categories, along with a sequential additional slowing in rents. I have rents a trifle softer too, but not a ton.
- Traders on Kalshi though MUST have big declines in rents penciled in. The Kalshi forecast for core is among the lowest out there, AND it has been really steady. Decent volumes (compared to history) too. Never say never.
- I think part of what is going on is that summer seasonals drag a lot from the NSA figure. By forecasting low month/month numbers, economists are basically saying the trends haven’t picked up like in a normal summer.
- I am not so sure of that. A lot of those are broad trends, not just in Lodging Away from Home or rents. But I think that’s the source of some of these soft forecasts, implicitly.
- A quick look at the month’s trading leading up to this. Pretty stable overall. Yields are significantly higher, but not in a sloppy way, and breakevens/CPI swaps only marginally wider. Slow summer trading for the most part it seems!
- One final note here. I said last month that we want to see the numbers not only head lower but also BROADLY lower, not just pulled lower by a few outliers. That means rents, it means services ex-rents. Not just health care services, not just Used Cars.
- So we will look beyond the headline for that. Good luck!
- Kalshi ftw I guess! 0.158% on Core and 0.180% on headline.
- First glance, I see -8.11% on Airfares and -2.01% on Lodging AFH. I still don’t see any airfares declining but they have been for several months. This is a BIG one.
- This clearly looks like a trend change, but I’d be a little careful.
- Decline in Education/Communication. Everything else positive but very tame.
- Core goods (+1.3% y/y) went back down, although I suspect that’s mostly base effects. Core Services turning down more in earnest (+6.2%). But again…
- OER and Primary rents have clearly peaked, but no surprise there. OER was +0.45% m/m, down sequentially from +0.52% last month; Primary rents were +0.46%, down from +0.49%. No collapse here.
- So this tells the story better. My estimate of Median is 0.365% m/m. Still better! But not the collapse that core is suggesting. Which tells you the core drop is a tail thing.
- Sorry, make my estimate 0.359%. Energy Services looks like the median category.
- So the “COVID Categories” are where the intrigue is. Airfares as I said, -8.1% m/m. Lodging Away from Home -2.01% m/m. Used Cars was -0.45%, not as low as I’d expected but not an add. Motor Vehicle Insurance was +1.41% m/m…and probably will continue to be. New cars -0.03% m/m.
- Car/Truck Rental -1.43% m/m. Baby Food -1.29%. Health Insurance the usual (for this year; reversing some next year) -3.61% m/m. College tuition is interesting, flat on the month.
- But look: Food Away from Home: +0.38% m/m. Remember, that’s wage-sensitive. So let’s look at the four pieces and see what is happening to core services ex rents.
- Before we do though, here is a chart of (NSA) Airfares. According to the BLS, airfares are back down to where they were pre-Covid. I do not understand that one.
- Piece 1: Food and Energy. Declining on a y/y basis. Now, Food overall was up this month, so was energy, but less than the normal seasonals would suggest and less than last year.
- This was always going to happen – food and energy mean-revert. It was only a surprise in how long it took.
- Core goods, shown before. This is partly due to better supply chains but also partly due to dollar strength. The question is whether it goes back to 0% or slightly negative. I think that’s unlikely, and it matters for whether inflation ultimately settles back where it started.
- Core Services less Rent of Shelter – this looks great! The usual reminder that some of it is a function of the Health Insurance drag that will stop in a few months, and eventually reverse. This will make the Fed feel better though. Yeah, it’s probably not as good as it looks.
- And piece 4, Rent of Shelter. Still way up there, but hooking lower. Is it going to 3% like some forecast? No.
- Core ex-housing dropped to 2.80% y/y, the lowest since March 2021. Part and parcel of the overall nice tone to these numbers. But a lot of them still trace back to a few things, which we’ll see when we look at the distributions.
- This chart won’t change your life but I just want to update it with today’s numbers. Again I wonder what the people calling for an uptick in Used Car prices were looking at. Very modelable.
- Don’t think I said that my estimate of y/y Median is 6.45%, down from 6.74% last month and 7.20% in February.
- Biggest declines (annualized m/m): Public Transport -57%, Lodging Away from Home -22%, Car/Truck Rental -16%. See any outliers? Biggest increases: Motor Vehicle Insurance +22%, Motor Vehicle Maintenance/Repair +17%. Striking the low and high outliers sort of balance except…
- And yeah, most of “Public Transportation” is Airline Fares. Other intercity transportation and Intracity transportation are small weights (and both positive m/m btw). The NSA decline in Airline fares was -6.5%. So not a seasonal glitch: airline fares are plunging. (?)
- Just speculating…there’s been a lot of talk about the improved fuel efficiency so passenger miles are running far ahead of jet fuel demand. So maybe some of this is passing the increased efficiency on to customers (through competition, not benevolence).
- Congrats to anyone who saw that coming to that degree.
- Getting into some of the diffusion stuff. This is the Enduring Investments Inflation Diffusion Index. Dropping all the way to 12 this month. Very good news.
- So gasoline and public transportation go into the mental model of the consumer as one chip each, even though the average consumer buys FAR more gasoline than public transport. But those chips in “transportation” aren’t the same as those in “the food aisle.”
- Anyway that’s the short version.
- Just saw Wireless Telephone Services was -1.46% m/m NSA. That’s odd – ever since data became basically free, the steady deterioration in wireless telephony costs has stopped. This won’t be repeated. The category is 1.8% of core so that’s 2.6bps of drag.
- Last chart. You can see that there is a big weight in 2%-and-under items, a secondary distribution/smattering around 5ish, the two big spikes for shelter, and some far-right-tail items. This is an unclear picture.The far-left items are mostly goods, and the rest mostly services.
- We can all “know” that the airfares and wireless stuff won’t be repeated, and recognize that wage growth is still high (6% on the Wage Growth Tracker) so the important wood is yet to chop. But shelter is in slow retreat, and overall trends look good.
- The data is not exacting any price for a Fed pause. And indeed, hiking into this presents the risk of looking like too much, later. I think the odds of a Fed hike just dropped a lot (I never thought the argument in favor of one was very good, though).
- OK, let’s do a conference call in 5 minutes, at 9:45ET. Call in if you want! [REDACTED] Access Code [REDACTED]
There is no doubting that this was a good number for the market, for the Fed, and for consumers. Yes, core inflation is still 4.8% y/y and Median is still well above 6%. But they’re declining, and that decline will continue.
It’s important to recognize, though, that there has been little debate that there is a deceleration coming in the y/y, partly because of base effects but partly because the Fed has stopped squirting liquidity everywhere. The question is whether inflation is headed back to 2% any time soon. Note that core goods is still well above zero, even with a very strong dollar. If Core Goods doesn’t get negative, there’s not much chance at getting core inflation back to 2% (and note that home prices are rising again, which puts paid to the argument that rents are going to imminently collapse because home prices are going to decline).
What we didn’t see in this figure was the broad deceleration that we really need to see. It is broadening, I suppose, which is why median CPI is slowly declining. We saw huge drops in a few categories that won’t be repeated. Airfares. Cell phones. What we didn’t see were huge jumps in any categories, and that’s encouraging.
The most interesting (and non-repeatable) part of the CPI data was airfares, which was a 5bp drag on core CPI. Amazingly airfares in the CPI are back to the level (not inflation rate, but the price level) seen prior to COVID. Part is lower jet fuel prices, as the regression above showed. But there’s more to it.
I find it plausible that some of the decline in airfares is due to less fuel intensity: more passenger miles with less jet fuel, which is a trend we’ve seen in the weekly energy data. But…have you really seen air fares going down? I haven’t. But I wouldn’t discard this data or expect it to reverse on that basis. Here’s one possible explanation, which is potentially a good reminder not to rely too much on anecdotal evidence without remembering to put the accent on “anecdotal” more than “evidence”: I don’t fly business class, and I don’t buy business tickets. If I were an airline, that’s where I’d be cutting prices – for the non-leisure traveler. Business travel is down, for sure, and is far more discretionary than it used to be. So if you cut the price to the business traveler, overall fares can decline…even if you and I aren’t seeing them. By the way, that’s not the BLS explanation but my supposition.
We need to remember that prior to this figure, there was strong stasis at about 0.4% for core CPI. It’s difficult for me to believe that we jumped from ~5% annualized to ~2% annualized on core, without a stop in between. That being said…this sort of number is great for stocks, and great for bonds, compared to just about any other print. I don’t necessarily think it’s a sign of a sea change, because the big slow-moving parts of CPI aren’t decelerating very quickly. But I can understand the enthusiasm in the markets among those who ignore value and ‘just trade the number’.
This figure also puts the Fed in a bind…or it would, if you really believe the Fed earnestly wants to yank rates up another 50-100bps. I don’t believe that, and think the Fed speakers are mostly burnishing their hawkish credentials to keep markets from getting ahead of themselves. Indeed, they might speak more hawkishly after this, making clear that further hikes are still on the table even though the odds of taking a pass this month just went up a lot.
So enjoy the number! But don’t necessarily get used to it. (That said…Kalshi traders right now have Core CPI for next month at 0.16% m/m. And they were right this month! But repeating this figure without airfares and cell phones will be a serious trick.)
