Archive for October, 2023

How Higher Rates Cause Big Changes in the Bond Contract

October 17, 2023 4 comments

Two weeks ago I pointed out one of the effects of higher interest rates is that leveraged return strategies get swiftly worse as rates rise. Today, I want to talk about another result of higher interest rates which is, to me, much more fun and exciting. It involves the Treasury Bond cash-futures basis.

I know, that doesn’t sound so interesting. For many years, it hasn’t been. But lately, it has gotten really, really interesting – and institutional fixed-income investors and hedgers need to know that one of the major effects of higher interest rates is that it makes the bond contract negatively convex, not to mention that right now the bond contract also looks wildly expensive.

Some background is required. The CBOT bond futures contract (and the other bond contracts such as the Ultra, the (10y) Note, the 5y, and the 2y) calls for the physical delivery of actual Treasury securities, rather than cash settlement. Right now, thanks to ‘robust’ Treasury issuance patterns, there are an amazing 54 securities that are deliverable against the December bond futures contract. The futures contract short may deliver any of these bonds to satisfy his obligations under the contract, and may do so any time within the delivery month.

Now, if we just said the short can deliver any bond, the short would obviously choose the lowest-priced bond. The lowest-coupon bond is almost always going to be the lowest-priced; right now, the 1.125%-8/15/2040 sports a dollar price of 55.5.[1] But if we already know what bond is going to be deliverable, and it’s always the optimal bond to deliver, then the futures contract is just a forward contract on that bond, and it becomes very uninteresting (not to mention that liquidity of that one bond will determine the liquidity of the contract). So, when the contract was developed the CBOT determined that when the bond is delivered it will be priced, relative to the contract’s price, according to a conversion factor that is meant to put all of the bonds on more or less similar footing.[2] The price that the contract short gets paid when he delivers that particular bond is determined by the futures price, the factor, and the accrued interest on the delivery date…and not the price of the bond in the market.

Because the conversion factor is fixed, but the bonds all have different durations, which bond is cheapest-to-deliver (“CTD”) changes as interest rates change. When interest rates fall, short-duration bonds rise in price more slowly than long-duration bonds and so they get relatively cheaper and tend to become CTD. When interest rates rise, long-duration bonds fall in price more quickly than short-duration bonds and so tend to become CTD in that circumstance. And here’s the rub: when interest rates were well below the 6% “contract rate”, the CTD bond got locked at the shortest-duration deliverable, which also usually happened to be the shortest-maturity deliverable, because that bond got cheaper and cheaper and cheaper as the market rose and rose and rose. The consequence is that the bond contract, as mentioned earlier, eventually did become just a forward contract on the CTD (and a short-duration CTD at that), which meant that the volatility of the futures contract was lower, the implied volatility of futures options was lower, and the price of the futures contract was uninteresting to arbitrageurs because it was very obviously the forward price of the CTD. And this situation persisted for decades. The last time the bond and 10-year note yielded as much as 6% (which is where all of the excitement is maximized, since after all the conversion factor is designed to make them all more or less interchangeable at that level) was 2000. [Coincidentally or not, that was right about the time I stopped being exclusively a fixed-income relative value strategist/salesman and started trading options, and then inflation.]

So, now the long bond yields 4.96% and the deliverable bonds in the December bond contract basket have yields between 5.03% and 5.22%. This starts to get interesting. As of today, the CTD bond is the 4.75%-Feb 15, 2041. If you buy that bond and sell the contract,[3] then the worst possible case for you is that you deliver that bond into the contract and lose roughly 12/32nds after carry.


Because you are short the futures contract, you can deliver whatever bond is most-advantageous to you at the time you elect to deliver. If any other bond is cheaper than the 4.75s-Feb41, then you buy that bond, sell the Feb41s, and deliver. And obviously, that’s a gain to you. And you can make that switch as often as you like, up until delivery.

Can you predict approximately when the bonds will switch? Sure, because we know the bonds’ durations we can estimate the CTD – and the value of switching – for normal yield curve shifts. While the steepening and flattening of the deliverable curve also matter, remember that anything that adds volatility to the potential switch point adds value to you, the futures short. Here is, roughly, the expected basis at delivery of that Feb41 bond.

Now isn’t this interesting? If the bond market rallies, then we know that shorter-duration bonds will become CTD, pushing the Feb 41s out. And if the bond market sells off, then we know that longer-duration bonds will replace the Feb 41s as CTD. Notice that this looks something like an options strangle? That’s because it essentially is. You own a strangle, and you’re paying 12/32nds for that strangle. (Spoiler alert: you can sell a comparable options position in the market for roughly 28/32nds, making the basis of that bond about half a point cheap, or equivalently the futures are about half a point rich.

Okay – if you’re not a fixed-income relative value strategist…and let’s face it, they’re a dying breed…then why do you care?

If you’re a plain old bond portfolio manager, you may use futures as a hedge for your position; you might use futures to get long bonds quickly without having to buy actual bonds, or because you aren’t allowed to repo your physical bonds but you can get some of the same benefits by buying the futures contract. You might buy options on futures to get convexity on your position, or to hedge the negative convexity in your mortgage portfolio.

Well guess what! None of that stuff works the same way it did 15 months ago!

Because longer-duration bonds are CTD now, the contract has more volatility. Which means the options on those futures have more implied volatility. Also, the bond contract is no longer guaranteed to be within a tick of fair value because the CTD is locked. When I worked for JP Morgan’s futures group, we thought if the futures contract got 6 ticks rich or cheap it was exciting. Well, we’re looking at a futures contract that’s a half-point mispriced![4]

Finally – as I said, the bond contract now has negative convexity, which means that when you are long the contract you will underperform in a rally and underperform in a selloff (while earning the net basis of 12 ticks, in a best case). Because when you own the bond contract you have the opposite position I’ve illustrated above: you’re short a strangle. If you’re long the contract then as the market sells off the bond contract will go down faster and faster as it tracks longer and longer duration deliverables. And if the market rallies, the contract will rise slower and slower as it tracks shorter duration deliverables. The implication is that especially because the bond contract is rich, it is great as a hedge for long cash positions at the moment, and a pretty bad hedge for short positions. And it’s great to hedge long mortgage positions, since when you sell the contract you also pick up some convexity rather than adding to your short-convexity position.

This all sounds, I’m sure, very “inside baseball.” And it is, because most of the people who used to trade this stuff and understood it are retired, have moved to corner offices, or are old inflation guys who just wonder why we don’t have a deliverable TIPS contract. But just as with my article two weeks ago, it’s something that I think it important to point out. We’re so obsessed with the ‘macro’ implications of higher rates, we stand to miss some of the really important implications on the ‘micro’ side of things!

[1] I’m using decimals to make this more accessible to non-bond folks, but we all know that this really means 55-16.

[2] The conversion factor is the answer to the question, “what would the price of this bond be if, on the first day of the delivery month, it were to yield exactly 6% to maturity”? So the aforementioned 1-1/8 of Aug-40s have a conversion factor into the December contract of 0.4938 while the 3-7/8 of Aug-40 has a conversion factor of 0.7794.

[3] I am abstracting here from the more technical nuances of how one weights a bond basis trade, again for brevity and accessibility.

[4] There’s a big caveat here in that the yield curve dynamics in my model for the shape of the deliverable bond yield curve are out-of-date, as I haven’t used this model in years…so the contract might be anywhere from 10 ticks to 20 ticks rich. But it’s rich!

Summary of My Post-CPI Tweets (September 2023)

October 12, 2023 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. 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 October (September’s figure).
  • At 8:30ET, when the data drops, I will pull down the data and then run a bunch of charts. Then I’ll comment and post some more charts. As usual. But nearing the end of this string. December is the last month I’ll do this live.
  • Later, I will post a summary of these tweets at and then podcast a summary at . Those will continue after the live tweeting stops in 2024!
  • The estimates for this month’s CPI data are fairly uniform across sources in expecting 0.26% m/m core, and 0.31% or so on seasonally-adjusted headline. My forecasts are a bit higher on Core, but in-line on headline. Here’s why.
  • First of all, while used car prices declined this month they fell by less than the seasonal adjustment factor would suggest. Instead of -1.9%, which is the non-seasonally-adjusted pace that Kalshi shows for its used car CPI market, I see +1.3% for the SA pace.
  • However, there’s a huge amount of variance there so I am actually penciling in flat. Partly, that’s also because used car prices haven’t yet fallen as much in the CPI as the Black Book survey would project, so maybe I’m too high.
  • Used car auctions in the latter half of this month were very strong, though, thanks to the strike against US auto makers. That hasn’t yet affected sales, but the auctions show it SHOULD affect prices since there is less reason to clear the lot if there are no more cars coming.
  • But although used car auctions have been strong, I don’t expect CPI to LEAD the Black Book survey. CPI almost never leads.
  • So if new car CPI isn’t strong this month, I expect it to be strong next month. Ditto with used cars. In fact, “if not this month, next month” will be a constant theme here.
  • Same is true of airfares, which last month rose about 5% but still lag far behind jet fuel – which has continued to rise. I expect another add there. And Lodging Away from Home was a surprise decline last month, which I am expecting to reverse this month.
  • Now, this month we do still have the 4bps drag from health insurance…but that reverses next month. Enjoy it while you can.
  • We are coming to the end of several of these trends that have flattered the CPI (or flattened it) recently: health insurance & the drag from used cars being the big ones. Used cars still has downward pressure from rates, but the strike is more important.
  • Thus, while y/y core CPI should get down to 4.1% or 4.2% this month (due also to easy comps vs 2022), getting it BELOW 4% is going to be tougher.
  • One trend that will be continuing for a while is the slow (accent on slow) deceleration in shelter inflation. Last month, OER was +0.38% and Primary Rents +0.48% m/m. That was right on my model. This month I have Primary Rents at +0.40% m/m, and the combination at +0.38% m/m.
  • Obviously the rent thing will continue for a while, but it won’t slow down as fast as people expect. I think that must be the reason that the consensus forecasts are soft given the obvious adds this month. So we will see.
  • Interestingly, the consensus on headline is roughly where MY headline estimate is despite my higher core. That means economists see food and energy adding more than I do. I don’t see that. Gasoline was basically flat Sept/Aug. I have 1bp from energy and 1bp from food.
  • Of course, with war in the Middle East – though weirdly, energy markets have been incredibly insouciant here – there is much more upside potential to energy prices going forward. And not much downside, unless growth collapses.
  • And while there are plenty of people looking for a growth collapse…I don’t see that. A recession, definitely, but a deep one? One that damages the financial infrastructure? Not really. Might be long, but not deep. And with inflation as well.
  • From a markets perspective, it has been a weird month in inflation. Real rates have shot up MORE than nominals, which is something you’d expect at the start of an expansion, not with recession coming on.
  • Breakevens are DOWN even though overall rates are UP, in other words. It’s bizarre;as I said in my podcast last week TIPS are finally an absolute buy, not just a relative buy compared to very-expensive nominals.
  • Incidentally, also take a look at the nice Q&A that Praxis did with me this week.
  • And while I’m thinking about it, take a look at the new Enduring website:
  • I said last month: “I think markets recognize that the narrative is turning, from “we are in an inflationary spiral” to “inflation is coming down” to “okay now it gets harder.” And that leaves breakevens a bit aimless for now.”
  • Still true…but we are further into that turning. It gets more difficult now. The Fed’s job is also getting more difficult, but we’ll wait to see what this number is before talking too much about that.
  • That’s all for the (short) walkup. Good luck today!

  • We are at 0.323% on Core, and 0.396% headline, so higher than expectations. BLS made some more changes in the way they roll out the release, so I’m about 1 minute behind schedule.
  • I can already see Used cars was a drag but rents a big gain as OER rebounded from last month and Lodging Away from Home bounced (as expected).
  • m/m CPI: 0.396%   m/m Core CPI: 0.323%
  • Last 12 core CPI figures
  • OK, so looking at this…it’s a bad number but a lot of this is probably going to trade to OER. Still, June and July start to look like the aberrations they were.
  • M/M, Y/Y, and prior Y/Y for 8 major subgroups
  • Nothing really stands out here…Housing obviously strong.
  • Core Goods: 0.0221% y/y           Core Services: 5.69% y/y
  • The overall trends in core goods and services are positive. Core goods going negative y/y is lower than I think is sustainable, and it should start to turn. Although with the dollar as strong as it is, it’ll take longer than I had been expecting.
  • Primary Rents: 7.41% y/y           OER: 7.08% y/y
  • So you can see no big change on the y/y trends. They’re slowing, but (as I’ve said) they’re not slowing as fast as everyone seems to think they will. OER’s jump this month will get the press, but overall the trend is in line.
  • Further: Primary Rents 0.49% M/M, 7.41% Y/Y (7.76% last)       OER 0.56% M/M, 7.08% Y/Y (7.32% last)       Lodging Away From Home 3.7% M/M, 7.3% Y/Y (3% last)
  • However, the m/m on primary rents also are higher than my model. Remember, costs for landlords are continuing to rise – it’s hard to imagine that rents will actually decline and landlords will just accept losses. There’s new supply, but way more new demand from immigration.
  • Some ‘COVID’ Categories: Airfares 0.28% M/M (4.89% Last)      Lodging Away from Home 3.65% M/M (-2.97% Last)      Used Cars/Trucks -2.53% M/M (-1.23% Last)      New Cars/Trucks 0.3% M/M (0.27% Last)
  • The rise in airfares is still lower than it should be and I will expect a further increase next month. Lodging Away from Home was an expected bounce, and on par. The decline in Used cars is probably at least temporarily over thanks to the strikes – we will see it next month.
  • Here is my early and automated guess at Median CPI for this month: 0.439%
  • The caveat to my median estimate is that the median category is a regional OER, which I have to guess at seasonal adjustment for. But this is the highest median since February. Again, July was an obvious outlier and now it’s more obvious.
  • Piece 1: Food & Energy: 1.96% y/y
  • No surprise there’s a bounce in food and energy y/y this month.
  • Piece 2: Core Commodities: 0.0221% y/y
  • Piece 3: Core Services less Rent of Shelter: 3.56% y/y
  • This includes Health Insurance…and that will reverse next month. Instead of dragging 4bps/month on core, and 10-12 on this subgroup, it’ll be adding back 2bps/month on core.
  • Piece 4: Rent of Shelter: 7.2% y/y
  • In the good-news category, Core ex-housing is down to 1.97% y/y. So, if you ignore housing, the Fed is at target. Except that’s largely thanks to Used Cars and Health Insurance decelerations, both of which are tapped out. As I said, it gets harder from here.
  • Core Categories with the largest m/m declines (annualized): Jewelry/Watches (-27%), Used cars & Trucks (-26%), Women’s/Girls Apparel (-20%), Infants’ Toddlers’ Apparel (-18%), Motor Vehicle Parts & Equipment (-16%). This last one also is probably going to reverse due to strikes.
  • Biggest annualized monthly gainers: Lodging AFH (+54%), Misc Personal Goods (+22%), Motor Vehicle Insurance (+17%), Misc Personal Services (+14%), Tenants/Household Insurance (+11%), Alcoholic Beverages (+10%).
  • Further to that, Misc Personal Services was +1.1% m/m and Misc Personal Goods was +1.7%. Those only sum to one percent of the whole CPI so not a big deal. A big reason that the “Other” subindex was +0.57% m/m though.
  • I have to confess a little surprise that yields and BEI aren’t up more on this. Yes, some will say it’s “just OER” and that looks like something of a makeup number…but at the VERY LEAST it should make the disinflationists question that KEY PART of their theory.
  • Maybe…just maybe…rents aren’t going to collapse into deflation? I dunno, just spitballing here, but since there’s no sign of it, and home prices are rising again…a number like this ought to at least make you think about the possibility.
  • OK, the response after the initial drop-and-bounce looks like people are having a think. I should say that I don’t think this changes the Fed’s trajectory – they’re done, although this brings in the chance for one more 0.25% to appease the hawks.
  • But clearly, 500bps of rate hikes hasn’t done the trick so what will 25 or 50 more do? Or 200? All that will do is slow the economy, without hurting inflation. There is little to no evidence that rate hikes push inflation lower, and at this point even the hawks must be noticing.
  • Running some diffusion stuff now. The story there continues to be positive. But we always knew the spike wouldn’t last forever – the question now is, where does inflation fall to? And so far, there’s no sign we’re going to plunge back to 2%. The hard part has started.
  • Another diffusion chart. Slightly worse this month (this is based on y/y), but overall improving. However, again…if 55% of the CPI, or 30% + OER, are still inflating faster than 4%…you’re not back to target yet. Far from it.
  • That’s enough for today. The summary is that the big surprise was rents, but outside of rents the news wasn’t so wonderful that we can ignore the fact that rents are not decelerating as fast as people expected. I continue to expect core of high 3s, low 4s for 2023. On track.
  • Thanks for tuning in. Be safe out there!

I started out with the theme “if not this month, then next month,” but we can dispense with that theme. Although that can be said of Used Cars, and Airfares – both which were lower than I expected – the more accurate theme is the one I started teasing last month: “now it gets harder.”

The lion’s share of the deceleration in core goods is over with. While the dollar’s continued strength will remain a pressure on goods prices, we’re down to zero in a category that even before COVID was only deflating 1-2% per year. And in the post-COVID, de-globalizing world, we are unlikely to see core goods prices sustainably deflating.

The decline in health insurance CPI is over with. Over the last year, that declined almost 4% per month and dragged 4bps per month on core CPI. In the coming 6 months, that is going to be an add of something like 2bps per month. You were sailing with that wind but now the wind is in your face.

Energy prices, a continued drag since the Biden Administration started flushing the SPR, are no longer going to drag. Whether or not gasoline prices rise back to the level they were prior to the SPR releases, they’re not going to be headed much lower especially with war in the Middle East. While the market seems amazingly insouciant about the widening of that war – “hey, neither Israel nor Gaza produce much oil so we good” – this does not feel like prior Israeli-Palestinian conflicts to me. Recent oil inventory numbers have been volatile and confusing, but unless the US recession is sharper or deeper than I (or OPEC) expect the cartel is likely to be able to keep prices high especially in an era when the US is not producing with heartfelt enthusiasm.

Further decelerations in rent are still ahead. But none of my models have primary rents slowing to below 3%, and that’s in contrast to what seems to be a general consensus that rents will outright decline nationally. I don’t see it.

The decline in rents is a big part of why core is down to the low 4%s, and will drop further over the next year even with other things no longer dragging. But again, this is no longer about when the peak in inflation will get here – it’s about where inflation is going to decline to. From 6.6% to 4.1% was the easy part. From 4.1% to 3% is going to be difficult. From 3% to 2%? So far, I don’t see anything that gets us there.

Higher Rates’ Impact on Levered Strategies

October 4, 2023 2 comments

I am old enough (fortunately??) to be able to remember when interest rates were last at this level. Even higher – I can remember in my first job, at technical analysis firm Technical Data, being tasked with updating the point-and-figure chart of the 10 3/8 – 2012 as it rallied from 9%! I mention this because, as interest rates have headed back higher I have noticed that a lot of people don’t remember some of the investment implications of higher rates. So, I want to review one of them today. Next week, I’ll write about how the rise in rates will tend to make bond futures negatively convex after years of positive convexity…there aren’t many bond basis traders left, because it’s been years since there has been a shift in bond deliverables, but it makes a lot of things more interesting and I suspect will resurrect some old relative-value trades that haven’t been seen in a dog’s age.

But today, I want to point out one big effect on the hedge fund industry: higher interest rates leads to lower hedge fund risk-adjusted returns, directly and significantly. If you’re a hedge fund, you already know this. If you’re an allocator, you may or may not realize that you need to carefully monitor any changes in the risk-taking of your existing hedge fund portfolio, and start to ask tougher questions of hedge funds touting high returns.

The dirty little secret of hedge fund returns is that you can make a good edge look like a fantastic return if leverage is cheap enough and if you lever enough. If I buy a bond yielding 5% with $100, and then borrow $90 at a 0% borrowing rate, by pledging that bond as collateral…and invest in another bond yielding 5%, then magically I have turned a simple bond-buying strategy into one that yields 9.5% (5% on 100, plus 5% on another 90, divided by the 100 in unlevered principal). Yes, I have almost doubled my risk but I have created a return that looks really nice.

But if instead of borrowing at 0% I am borrowing at 2.5%, then levering to buy that bond doesn’t add as much. The $90 spent on that 5% bond now costs me 2.5%, for a net 2.5% return on that piece. I still have the risk, but my return has gone down to 7.25%. If I can borrow another 90, and do the trick again, I’ll get back to my 9.5% return but now I’m 3x levered instead of 2x. (Naturally, most hedge fund strategies are more complex but this is the basic concept).

Now, for small changes in financing rates this is of course a small effect. And for decreases in financing rates, it’s a positive effect. But when you have large increases in interest rates, it has a big effect on returns:

Yes, I know this is overly simplistic but the easiest way to think about this is with a bond strategy where you’re leveraging up a simple yield. The significance of a change in the cost of leverage, though, is felt across many hedge fund categories. There’s an exception with many CTA strategies because there is no money required to hold the natural underlying. The longs and shorts are exchanging daily P&L, and no one actually needs to hold the underlying instrument because there isn’t any. Similarly, long/short bond and equity strategies, in principle, only care about the spread between the financing of the long position (which is paid) and the financing of the short position (which is earned) rather than its level, assuming equal notionals on long and short. But most long/short strategies – including fixed-income arbitrage, weirdly – are highly correlated to stocks, which suggests that in most cases there’s net long exposure. Here are charts of the CS long/short equity hedge index, and the Bloomberg Fixed-Income Arb index, against the S&P 500.

Managed futures, not so much, although there’s a decent correlation to commodity indices (not as much as in the above examples relating long/short returns to equity returns).

If a futures strategy or a long/short strategy holds unencumbered cash, they should get some benefit from higher rates…but most such strategies don’t tend to have a lot of unencumbered cash. In the same way, commodity futures indices such as the Bloomberg Commodity Index or the Goldman Sachs Commodity Index (and many others) get some benefit in expected returns because they earn more on the collateral they hold against futures positions, and they do hold a lot of cash and Tbills.

However you slice it, the sharply higher financing rate environment we are now in is likely to have a meaningful effect on the returns (and the risks, if more leverage is used to chase a higher return) of many hedge fund strategies. All else being equal, this will be a lower penalty on less-levered strategies; which means investor money should flow to less-levered strategies for a better risk-reward tradeoff.

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