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2024 Balance of Risks
I am a risk manager, both literally and figuratively. Literally, since whether it is with our own funds and strategies or allocations for individual investor clients, or with my trading book back when I worked on Wall Street, the hard constraints are always capital, capital, and capital and so managing risk is part of how you make sure you don’t lose that capital. But also figuratively – my natural disposition is conservative, which is why I am a bond guy (concerned with getting my original investment back at par, at the end) rather than an equity guy (filled with dreams of a 10-bagger because I’m the first guy to figure out that Blockbuster Video is going to revolutionize video rental, and not so worried about how it will vanish almost overnight to Netflix).
So when I look at the investing landscape, I’m generally not focusing very much on ‘what I think is going to happen’; rather I spend more time thinking about the range of possible things that might happen, and their relative likelihoods. In theory, all rational investors do this but the markets do not trade like it. For example, currently Crude Oil trading at $72.60 does not seem to put any weight on the possibility of a hot war in the Middle East that could abruptly spike prices to $125/bbl or more. That’s not a prediction there will be a conflict that disrupts oil production or distribution (which, since there’s already a conflict – even though it hasn’t impacted oil production and only marginally impacted distribution – doesn’t seem like the sort of tiny-risk possibility we can ignore), but merely an observation. If you think there’s even a 10% chance that oil spikes $50/bbl, it would be worth $5/bbl. “But Mike,” you say, “maybe that’s already in the price and but for that possibility oil would be $5 lower?” Well, the risk manager in me looks for confirmation that the market is at least a little nervous, and with the Oil VIX trading at its long-term average and well below the average of the post-2020 spike it strikes me as hard to characterize the energy markets as ‘nervous.’
Anyway, this is why I dislike year-end ‘outlook’ pieces and why when I forecast CPI for a year or two out I almost always focus on a range of probable outcomes rather than a point estimate.[1] Honestly we should all do this, but not enough people have studied enough statistics to understand the significance of the error bars. If you have an experimental mean, and a nice large error bar, it signifies that you can’t reject the possibility that the true mean is anywhere in the range covered by the error bar. And that’s why, when someone introduces a new rent index that supposedly is more current but by their own admission has 15 times the standard error…I ignore it.
Enough of the preliminaries. Let me get on with this. Here are my thoughts about the balance of risks for just a few important items:
Interest rates: balance of risks is clearly higher. This was even more true at the end of the year. But with 10-year rates at 4.11%, down from 5% in October, keep in mind that two ways to get lower interest rates are already priced in: the short end of the curve reflects expectations (despite Fed officials’ protestations to the contrary) of roughly 150bps of cuts in the overnight policy rate this year, and the long end reflects inflation expectations of only 2.27% inflation over the next 5 years and only 2.30% inflation over the next decade. On top of this, consider that with the trade deficit declining but the budget deficit not declining, more of the budget deficit will have to be funded from domestic saving – and the Fed is still shrinking its balance sheet, so it is pushing in the opposite direction. The balance of risks in the bond market is to higher rates.
Stock market: balance of risks is lower, with the caveat that the picture is much better if looking at the market ex-the ‘Magnificent 7’ hot stocks (Apple, Nvidia, Meta, Tesla, Amazon, Microsoft, and Google). The S&P currently has a P/E of 21.4 and is up 24% since the end of 2022. The S&P ex-Mag7 has a P/E of 18.4 and is up 11% since the end of 2022. The Magnificent 7 themselves have a P/E of 39.5 and are up 110% over the last year.
The overall market P/E looks not-too-bad, until you remember that this is only because profit margins are currently only just a bit below at least 30-year highs (and probably lots longer – this is as far back as Bloomberg has trailing-12-months margins). The balance of risks is definitely for lower margins, which means lower earnings, which means the same equity prices would represent higher P/Es. Oh, and whatever happened to those people saying that the high equity prices were due to the really low interest rates? Haven’t heard from them in a while.
Where I have clients who are long equities, they’re long equal-weight indices so as to lessen exposure to the Magnificent 7. But even if those stocks were the only ones overvalued, it’s not reasonable to think that they can come back to earth and not bring down the rest of the market. If Apple, Nvidia, Meta, and Microsoft drop 30%, the rest of the market isn’t going to go up. However, if such a thing were to happen the market outside of the Mag 7 could feasibly eventually get to looking cheap.
Credit spreads: balance of risks is wider, with the 10-year Baa credit spread near 30-year lows. Really, how low does this go? And the tails are obviously one-way.
So I’ve said the balance of risks favor higher interest rates, wider credit spreads, lower corporate margins, and lower equity prices. It’s also useful to think about where the risks are in my risk assessments. If we get lower interest rates, instead of higher, then it’s very likely due to the economy being a lot weaker than it currently is, and the Fed ends up having to ease more than 150bps in 2024. That seems unlikely to me, but if it happens then notice that probably also means that credit spreads will widen and corporate margins, earnings, and stock prices decline. So, if you’re bullish on bonds and stocks, it seems to me you’re taking a dangerously narrow path. The balance of risks to me look bearish on both sides of that, but the bullish outcome for bonds implies (I think) a bearish outcome for stocks. It’s difficult for me to see an environment with appreciably higher stocks and bonds, unless the Fed eases aggressively without any economic weakness. So that’s your implied bet.
On the other hand, being bearish both stocks and bonds doesn’t carry such a narrow path risk. Unless the Fed eases despite a solid economy, It isn’t hard to envision an environment with lower stocks and bonds. Heck, we had just such an environment a few months ago, pre-‘pivot.’ It’s not a reach.
None of the preceding is a forecast. But investing and trading are about evaluating the range of risks, and trying to take positions with asymmetric risk-adjusted payoffs. In my opinion, long-only investors should be playing short on the yield curve (and going up credit, and inflation-linked rather than nominal) and anti- cap-weighting their stock holdings.
That’s as close to an outlook piece as I am doing this year. Have fun.
[1] In the last few years, I’ve started putting a point estimate for CPI in my Quarterly Inflation Outlook, but I also report what I see as the 1 standard deviation range so I can indicate the skewness of the risks in my view.
How Higher Rates Cause Big Changes in the Bond Contract
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.
However.
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!
Higher Rates’ Impact on Levered Strategies
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.
What Happens if CPI Isn’t Released?
One thing I’ve stopped worrying very much about is a government shutdown. It could even be a good thing, given the bloated deficit, except for the fact that the government basically keeps spending anyway. The federal government employs about 4.5mm workers, and no more than 800k have every been furloughed – moreover, many of those furloughed workers often receive back pay. Social Security gets paid, Treasuries get paid, and the wheel keeps turning. That’s not a guarantee, of course – it’s possible that an extended shutdown could cause Treasuries interest to not be paid, but we all know that before that happens, the Fed would just print the money and make sure the checks go out. At worst, there could be a one-day technical default, if important people had given the heads-up to insiders to get really long CDS.
But my cynicism is getting the better of me so let’s turn to what could happen in a shutdown that impacts the inflation markets: in the past, some data releases of federal agencies have been delayed (or their quality impacted), and if the delay was long enough then it could affect TIPS. Lots of people are asking about this, so I thought I’d lay out what would happen and how.
First of all, the quality of the CPI data could potentially be impacted. That has happened in the past, because data collection agents are not ‘essential workers’ so if the government shuts down, a lot of the data collection stops. This is less of a problem than it has been in the past, though, because a lot more of the data is collected electronically than in the past. For example, the new cars sample is no longer collected by hand but is sourced from J.D. Power. Prescription drugs data is partly supplied by one large firm that didn’t want to allow data collectors to collect data in store. A similar story applies to apparel. Many of these ‘big data’ changes are discussed in this BLS white paper, but the point is that these changes also mean that the quality of the data won’t be impacted as much as would be the case if data collection was entirely done by hand as it once was.
The bigger potential problem is that the CPI report could be delayed.[1] The NSA CPI is used almost exclusively as the index in inflation swaps, and is the index that determines escalation of TIPS principals. Other subindices are used in contract arrangements (for example, in long-term airplane purchase contracts), but those applications are generally less urgent.
If the BLS is unable to release the CPI on October 12th, what happens? The first thing to know is that the September CPI (which is what is released in October) is only relevant to swap payments and TIPS accruals in November and December. For each day in November, the inflation index is interpolated between the August and September prints; for each day in December, the inflation index is interpolated between the September and October prints. Ergo, missing the September print would make it impossible to settle inflation swaps payments – but more importantly, every TIPS trade that settles in November or December would be impossible to settle because the invoice price couldn’t be calculated.
Fortunately, the Treasury thought about that a very long time ago. Title 31 of the Code of Federal Regulations (CFR) spells out what would happen if the BLS didn’t report a CPI by the end of October (it also spells out what happens if the BLS makes a large change to the CPI, or stops calculating it). In a nutshell, the Treasury would use the August CPI index, inflated by the decompounded year-over-year inflation rate from August 2022-August 2023:
I’ll do the math for you. If the CPI isn’t released, the figure for September will be 307.94834, which is +0.3004% on the month. While that sounds very convenient, since economists are forecasting a +0.3% m/m change for this data point, remember that the economists’ +0.3% is seasonally adjusted while the +0.3004% change is NSA. The difference is that 0.3004% NSA is about 0.50% SA this month.
Naturally, this wouldn’t matter very much in the long run; once the October CPI was released at the proper level the artificial change from Sep-Oct would wash out the artificial change for Aug-Sep.
Except, that is, for one pain-in-the-ass way, and that is the second part of the code snippet shown above: the Treasury would never adjust the official number back to match the BLS back-dated release of September CPI. Forever after, if you ran the sequence of monthly Treasury CPI Index numbers and the BLS CPI numbers, they would be exactly the same except for the one data point. The economic significance of that approaches zero, but the Inflation-Guy-Irritation figure on that approaches infinity.
So let’s hope cooler heads prevail.
[1] How likely is this? Kalshi has a market for this as well as markets on the probability of a government shutdown and the length of a government shutdown. As of this writing, Kalshi traders are saying there is an 18% chance that the CPI data will not be released in October.
Three Colliding Macro Trends
It’s ironic that I had planned this column a couple days ago and started writing it yesterday…because the very concerns I talk about below are behind the overnight news that Fitch is lowering its long-term debt rating for US government bonds one notch to AA+. That matches S&P’s rating (Moody’s is still at Aaa).
Let me say at the outset that I am not at all concerned that the US will renege on its bonds in the classic sense of refusing to pay. Classically, a government that can print the money in which its bonds are denominated can never be forced to default. It can always print interest and principal. Yes, this would cause massive inflation, and so would be a default on the value of the currency. Again classically, this is no decision at all. However, it bears noting that there may be some case in which the debt is so large that printing a solution is so bad that a country may prefer default so that bondholders, and not the general population, takes the direct pain. I don’t think this is today’s story, or probably this decade’s story. Probably.
But let’s get back to what I’d intended to talk about.
Here are three big picture trends that are tying together in my mind in a way that bothers me:
- Large, and increasing (again), federal deficits
- An accelerating trend towards onshoring production to the US
- The Federal Reserve continuing to reduce its balance sheet.
You would think that two of the three of those are unalloyed positives. The Fed removing its foot from the throat of debt markets is a positive; and re-onshoring production to the US reduces economic disruption risks in the case of geopolitical conflicts and provides high-value-add employment for US workers. And of course all of that is true. But there’s a way these interact that makes me nervous about something else.
This goes back to the question of where the money comes from, to fund the Federal deficit. I’ve talked about this before. In a nutshell, when the government spends more than it takes in the balance must come from either domestic savers, or foreign savers. Because “foreign savers” get their stock of US dollars from our trade deficit (we buy more from Them than They buy from us, so we send them dollars on net which they have to invest somehow), looking at the flow of the trade deficit is a decent way to evaluate that side of the equation. On the domestic side, savings comes mainly from individuals…and, over the last 15 years or so, from the Federal Reserve. This is why these two lines move together somewhat well.
Now, you’ll notice that in this chart the red line has gone from a deep negative to be basically flat. The trade deficit has improved (shrunk) about a trillion since last year, and the Fed balance sheet has shrunk by 800bln or so. But, after improving for a bit the federal deficit is now moving the wrong direction, growing larger again even as the economy expands, and creating a divergence between these lines. This is happening partly although not entirely because of this trend, which will only get worse as interest rates stay high and debt is rolled over at higher interest rates:
The problem in the first chart above is the gap that’s developing between those two lines. Because the difference is what domestic private savers have to make up. If you’re not selling your bonds to the Fed, and you’re not selling your bonds to foreign investors who have dollars, you have to be selling them to domestic investors who have dollars. And domestic savers are, in fact, saving a bit more over the last year (they saved a LOT when the government dumped cash on them during COVID, which was convenient since the government needed to sell bonds).
So here’s the problem.
The big picture trend of big federal deficits does not appear to be changing any time soon. And the big picture trend of re-onshoring seems to be gathering momentum. One of the things that re-onshoring will (eventually) do is reduce the trade deficit, since we’ll be selling more abroad and buying more domestic production. And a smaller trade deficit means fewer dollars for foreign investors to invest. The big picture trend of the Fed reducing its balance sheet will eventually end of course, but for now it continues.
And that means that we need domestic savers to buy more and more Treasuries to make up the difference. How do you get domestic savers to sink even more money into Treasuries? You need higher interest rates, especially when inflation looks like it is going to be sticky for a while. Moreover, attracting more private savings into Treasury debt, instead of say corporate debt or equity or consumer spending, will tend to quicken a recession.
I don’t worry about recessions. They are a natural part of the business cycle. What I worry about is breakage. Feedback loops are a real part of finance, and out-of-balance situations can spiral. The large deficits the federal government is generating, partly (but only partly) because of prior large deficits, combined with the fact that the Fed is now a seller and not a buyer, and the re-onshoring trend that is slowly drying up the dollars we send abroad, creates a need to attract domestic savers and the only way to do that is with higher interest rates. Which, ultimately, raises the interest cost of the debt, which raises the deficit…
There are converging spirals, and there are diverging spirals. If this is a converging spiral, then it just means that we settle at higher interest rates than people are expecting but we end up in a stable equilibrium. If this is a diverging spiral, it means that interest rate increases could get sloppy, and the Fed could be essentially forced to stop selling and to start ‘saving’ again. Which in turn would provide support for inflation.
None of the foregoing is guaranteed to happen, but as an investment manager I get paid to worry. It seems to me that these three big macro trends aren’t consistent with stable interest rates, so something will have to give.
One of those things was the country’s sovereign debt credit rating. The Fitch move seems sensible to me, even if that wasn’t the original point of this article.
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.
Is Inflation Dead…Again?
I am not the first person to point out that the stock market, at outlandish multiples, is not behaving consistently with commodities markets that are flashing imminent depression. If we insist on anthropomorphizing the markets, it really makes no sense at all unless we posit that “the market” suffers from a split personality disorder of some kind. But that sort of thing happens all the time, in little ways.
But here is something that seems very weird to me. Prices of short-dated inflation swaps in the interbank market suggest that NSA headline inflation is going to rise less than 0.9% for the entire balance of 2023 (a 1.45% annualized rate). And actually, most of that rise will be in the next 2 months. The market is pricing that between June’s CPI print and December’s CPI print the overall price level will rise 0.23%…less than ½% annualized!
Now, eagle-eyed readers will notice that there was also a flat portion of 2022, covering roughly the same period. Headline inflation between June and December last year rose only 0.16%, leading to disappointing coupons on iBonds and producing proclamations that inflation was nearly beaten. Here’s the thing, though. The second half of 2022 it made perfect sense that headline inflation was mostly unchanged. Oil prices dropped from $120/bbl the first week of June, to $75 by mid-December. Nationwide, average unleaded gasoline prices dropped from $5 to $3.25 during that time period.
A comparable percentage decline would mean that gasoline would need to drop to $2.32 from the current $3.58 average price at the pump. To be sure, the gasoline futures market is in much steeper backwardation than normal, with about 44c in the curve from now until December compared with 28c from June to December 2024.[1] So that can’t be the whole source of this insouciance about inflation. If gasoline does decline that much, the inflation curve will be right…but there’s an easier way to trade that, and that’s to sell Nov or Dec RBOB gasoline futures.
So the flatness must be coming from elsewhere. It can’t be from piped gas, which has recently been a measurable lag, because Natural Gas prices have already crashed back to levels somewhat below the norm of the last 10 years. Prices of foodstuffs could fall back more, which would help food-at-home if it happened, but food-away-from-home tracks wages so it’s hard to get this huge of an effect from food.
Ergo…this really must be core. Except there, the only market where you can sort of trade core inflation rather than backing into it, the Kalshi exchange, has the current prices of m/m core at 0.35% in May, 0.32% in June, 0.57% in July, 0.45% in August, 0.35% in September, 0.18% in October, and 0.22% in November. (To be sure, those markets especially for later months are still fairly illiquid but getting better). That’s not drastically different from the 0.41% average over the last six months.
Markets, of course, trade where risk clears and not necessarily where “the market thinks” the price should be. I find it hard to understand though who it is who would have such an exposure to lower short-term prices that they would need to aggressively sell short-term inflation…unless it is large institutional owners of TIPS who are making a tactical view that near-term prints would be bad. Sure seems like a big punt, if so.
Naturally, it’s possible that inflation will suddenly flatline from here. I just don’t feel like that’s the ‘fair bet’. That is after all a key function of markets: offer attractive bets to people who don’t have a natural bias in the market in question, to offset the flows of those people who are willing to pay to reduce their risk in a particular direction. (This should not be taken to suggest that I don’t have a natural bias in the market; I do.)
There’s another reason that this matters right now. Recently, markets have also been starting to price the possibility that the Federal Reserve could continue to hike interest rates, despite fairly clear signals from the Chairman after the last meeting that a ‘pause’ was in the offing. That certainly makes sense to me, since 25bps or 50bps makes almost no difference and after one of the most-aggressive hiking cycles in history, putting rates at approximately long-term neutral at the short end, it would seem to be prudent to at least look around. If, in looking around, the Fed were to notice that the balance of the market is suggesting that inflation has a chance of going instantly and completely inert, it would seem to be even stranger to think that the FOMC is about to fire up the rate-hike machine again for another few hikes.
[1] N.b. – June to December on the futures curve isn’t the exact right comparison since prices at the pump lag wholesale futures prices, but it gives you an idea.
We Are All Bond Traders Now
When I started working in the financial markets, bond traders were the cool kids. The equity guys drove Maseratis and acted like buffoons, but the bond guys drove sensible style like Mercedes and cared about things like deficits and credit. The authoritative word on this subject came from the book Liar’s Poker by Michael Lewis, about 1980s Salomon Brothers, where the trainees dreaded being assigned to do Equities in Dallas.
Back then, equities guys worried about earnings, the quality of management and the balance sheet, and the really boring ones worried about a margin of safety and investing at the right price. That seems Victorian now, but I guess so does the idea that sober institutions should only own bonds.
Down the list of concerns, but still on it, were interest rates. Ol’ Marty Zweig used to have a commercial in which he said “if you can spot meaningful changes (not just zig-zags) in interest rates and momentum, you’ll be mostly in stocks during major advances and out during major declines.” The reason that interest rates matter at all to a stock jockey is that the present value of any series of cash flows, such as dividends, depends on the interest rate used to discount those cash flows.
In general, if the discount curve (yield curve) is flat, then the present value of a series of cash flows is the sum of the present values of each cash flow:
…where r is the interest rate.
As a special case, if all of the cash flows are equal and go on forever, then we have a perpetuity where PV = CF/r. Note also that if all of the cash flows have the same real value and are only adjusted for inflation, and the denominator is a real interest rate, then you get the same answer to the perpetuity problem.[1]
I should say right now that the point of this article is not to go into the derivation of the Gordon Growth Model, or argue about how you should price something where the growth rate is above the discount rate, or how you treat negative rates in a way that doesn’t make one’s head explode. The point of this article is merely to demonstrate how the sensitivity of that present value to the numerator and the denominator changes when interest rates change.
The sensitivity to the numerator is easy. PV is linear with respect to CF. That is, if the cash flow increases $1 per period, then the present value of the whole series increases the same amount regardless of whether we are increasing from $2 to $3 or $200 to $201. In the table below, the left two columns represent the value of a $5 perpetuity versus a $6 perpetuity at various interest rates; the right two columns represents the value of a $101 perpetuity versus a $102 perpetuity. You can see that in each case, the value of the perpetuity increases the same amount going left to right in the green columns as it does going left to right in the blue columns. For example, if the interest rate is 5%, then an increase in $1 increases the total value by $20 whether it’s from $5 to $6 or $100 to $101.
However, the effect of the same-sized movement in the denominator is very different. We call this sensitivity to interest rates duration, and in one of its forms that sensitivity is defined as the change in the price for a 1% change in the yield.[2] Moving from 1% to 2% cuts the value of the annuity (in every case) by 50%, but moving from 4% to 5% cuts the value by only 20%.
What this means is that if interest rates are low, you care a great deal about the interest rate. Any change to your numerator is easily wiped out by a small change in the interest rate you are discounting at. But when interest rates are higher, this is less important and you can focus more on the numerator. Of course, in this case we are assuming the numerator does not change, but suppose it does? The importance of a change in the numerator depends not on the numerator, but on the denominator. And for a given numerator, any change in the denominator gets more important at low rates.
So, where am I going with this?
Let’s think about the stock market. For many years now, the stock market has acted as if what the Fed does is far more important than what the businesses themselves do. And you know what? Investors were probably being rational by doing so. At low interest rates, the change in the discount rate was far more important – especially for companies that don’t pay dividends, so they’re valued on some future harvest far in the future – than changes in company fortunes.
However, as interest rates rise this becomes less true. As interest rates rise, investors should start to care more and more about company developments. I don’t know that there is any magic about the 5% crossover that I have in that chart (the y-axis, by the way, is logarithmic because otherwise the orange line gets vertical as we get to the left edge!). But it suggests to me that stock-picking when interest rates are low is probably pointless, while stock-picking when interest rates are higher is probably fairly valuable. What does an earnings miss mean when interest rates are at zero? Much less than missing on the Fed call. But at 5%, the earnings miss is a big deal.
Perhaps this article, then, is mistitled. It isn’t that we are all bond traders now. It’s that, until recently, we all were bond traders…but this is less and less true.
And it is more and more true that forecasts of weak earnings growth for this year and next – are much more important than the same forecasts would have been, two years ago.
But the bond traders are still the cool kids.
[1] I should also note that r > 0, which is something we never had to say in the past. In nominal space, anyway, it would be an absurdity to have a perpetually negative interest rate, implying that future cash flows are worth more and more…and the perpetuity has infinite value.
[2] Purists will note that the duration at 2% is neither the change in value from 1% to 2% nor from 2% to 3%, but rather the instantaneous change at 2%, scaled by 100bps. But again, I’m not trying to get to fine bond math here and just trying to make a bigger point.
The Quintillion-Dollar Coin
I was going to write a technical column today about how the sensitivity of bonds (and consequently, lots of other asset prices) to interest rates increases as interest rates decline, and discuss the implications for equity investors nowadays as interest rates head back up. That article will have to wait another week. Today, I want to just quickly dispense with a really silly idea that keeps making the rounds every time there is a standoff on the debt ceiling, pushed by the same guys who think Modern Monetary Theory (MMT) will work (even though we just tried it, and it didn’t).
The idea is that, thanks to a law passed back in the 1990s, the Treasury has the right to issue a platinum coin of any denomination. Ergo, it could produce a $1 Trillion coin, deposit it at the Federal Reserve (who does not have the option to not accept legal tender, Secretary Janet Yellen’s recently-voiced concerns notwithstanding), and continue to pay the government’s bills. Why? One well-traveled and entertaining simpleton started explaining the reasoning for doing this by saying “there’s this silly, anachronistic and ineffectual law on the books called the Debt Ceiling…”
If we started doing really really silly, not to mention stupid, things to get around every law that we thought was silly and anachronistic, legislators would be busy 24 hours a day, 7 days a week. (And, obviously, the law isn’t “ineffectual”; if it was then we wouldn’t need to get around it.)
I am continually amazed by how durable the really stupid ideas are. For instance, the notion that the government is lying about inflation to the tune of 6% per year is an idea that never seems to die even though you can show with basic math that it can’t possibly be the case. So, let’s dispense with this one even though I am sure I will have to keep slaying this dragon when it inevitably comes back from the dead.
A useful tool of logic that’s handy when you are trying to smoke out a dumb idea is to ask, “If that works, why don’t we do lots more of it?” Let’s not try to figure out why a $1 Trillion coin is a bad idea. Let’s try to figure out why a $1 Quintillion coin (a million trillions) is a bad idea.
After all, if we are going to mint a coin anyway, it doesn’t cost much more to stamp “Quinti” than it does to stamp “Tri”. And if the Treasury minted a Quintillion-dollar coin and deposited it at the Fed, it would be much more significant. With that balance, the Treasury could pay off all outstanding debt, fully fund Medicare and Social Security, and cancel all taxes basically forever while also dramatically increasing services! Why isn’t that a better idea? I spit on your Trillion-dollar coin.
Naturally, that would be a terrible idea and it’s now obvious why. I can think of several reasons, but I’ll leave most of them for other people to highlight in the comments. The immediate one is that by paying off all federal debt, increasing spending and decreasing taxes to zero, the money supply would increase immensely and immediately. As we saw quite recently, the result that rapidly follows is much higher inflation. Much much higher inflation. I will see your 8% and raise you 800%. Yes, to some extent that would depend on the Congress deciding to do that spending and cut those taxes – but do you doubt that would happen? And the Treasury offering to buy back all of the outstanding bonds wouldn’t need Congressional authorization. That’s trillions in money being suddenly returned to bondholders, which puts it back in circulation.
A trillion here, a trillion there, and pretty soon you’d be talking real money.
The Monetary Policy Revolution in Three Charts
Over the last few years, I’ve pointed out exhaustively how the current operating approach at the Fed towards monetary policy is distinctly different from past tightening cycles. In fact, it is basically a humongous experiment, and if the Fed succeeds in bringing inflation gently back down to target it will be either a monumental accomplishment or, more likely, monumentally lucky. My goal in this blog post is to explain the difference, and illustrate the challenge, in just a few straightforward charts. There are doubtless other people who have a far more complex way of illustrating this, but these charts capture the essence of the dynamic.
Let me start first with the basic ‘free market’ interest rate chart. Here, I am showing the quantity of bank lending on the x-axis, and the ‘price’ of the loan – the interest rate – on the y-axis. If we assume for the moment that inflation is stable (don’t worry, the fact that it isn’t will come into play later) then whether the y-axis is in nominal or real terms is irrelevant. So we have a basic supply and demand chart. Demand for loans slopes downward: as the interest rate declines, borrowers want to borrow more. The supply curve slopes upward: banks want to lend more money as the interest rate increases.
An important realization here is that the supply curve at some point turns vertical. There is some quantity of loans, more than which banks cannot lend. There are two main limits on the quantity of bank lending: the quantity of reserves, since a bank needs to hold reserves against its lending, and the amount of capital. These are both particular to a bank and to the banking sector as a whole, especially reserves because they are easily traded. Anyway, once aggregate lending is high enough that there are no more reserves available for a bank to acquire to support the lending, then the bank (and banks in aggregate) cannot lend any more at any interest rate – at least, in principle, and ignoring the non-bank lenders / loan sharks. We’re talking about the Fed’s actions here and the Fed does not directly control the leverage available to loan sharks.
Now, traditionally when the Fed tightened policy, it did so by reducing the aggregate quantity of reserves in the system. This had the effect of making the supply curve go vertical further to the left than it had. In this chart, the tightening shows as a movement from S to S’. Note that the equilibrium point involves fewer total loans (we moved left on the x axis), which is the intent of the policy: reduce the supply of money (or, in the dynamic case, its growth) by restraining reserves. Purely as a byproduct, and not very important at that, the interest rate rises. How much it rises depends on the shape of the demand curve – how elastic demand for loans is.
As an aside, we are assuming here that the secondary constraint – bank capital – is not binding. That is, if reserves were plentiful, the S curve would go vertical much farther to the right. In the Global Financial Crisis, that is part of what happened and was the reason that vastly increase reserves did not lead to massive inflation, nor to a powerful recovery: banks were capital-constrained, so that the Fed’s addition of more reserves did not help. Banks were lending all that they could, given their capital.
Manipulating the aggregate quantity of reserves was the way the Fed used to conduct monetary policy. No longer. Now, the Fed merely moves interest rates. Let’s see what effect that would have. Let’s assume for now that the interest rate is a hard floor, and that banks cannot lend at less than the floor rate. This isn’t true, but for ease of illustration. If the Fed institutes a higher floor on interest rates then what happens to the quantity of loans?
This looks like we have achieved the same result, more simply! We merely define the quantity of loans we want, pick the interest rate that will generate the demand for those loans, and voila, we can add as many reserves as we want and still get the loan production we need. The arrows in this third chart show the same movements as the arrows in the prior chart. The quantity of loans is really determined entirely by the demand curve – at the prescribed interest rate, there is a demand for “X” loans, and since banks are not reserve-constrained they are able to supply those loans.
However, it’s really important to notice a few things. The prior statement is true if and only if we know what the demand curve looks like, and if the floor is enforced. Then, a given interest rate maps perfectly into Q. But:
- D is not known with precision. And it moves. What is more, it moves for reasons that have nothing to do with interest rates: for example, general expectations about business opportunities or the availability of work.
- Moreover, D is really mapped against real rates, while the Fed is setting nominal rates. So, for a given level of a nominal floor, in real space it bucks up and down based on the expected inflation rate.
- Also, the floor is not a hard floor. At any given interest rate where the floor would be binding, the desire of banks to lend (the location of the S curve) exceeds the demand for loans (by the amount of the ?? segment in the chart above). The short-term interest rate still affects the cost to banks of that lending, but we would still expect competition among lenders. This should manifest in more aggressive lending practices – tighter credit spreads, for example, or non-rate competition such as looser documentary requirements.
In the second chart I showed, the Fed directly controlled the quantity of reserves and therefore loans. So these little problems didn’t manifest.
Now, there is one advantage to setting interest rates rather than setting the available quantity of reserves as a way of reducing lending activity. Only the banking sector is reserve-constrained. If there is an adequate non-bank lending network, then the setting of interest rates to control the demand for loans will affect the non-bank lenders as well while reserve constraint would not. So this is somewhat “fairer” for banks. But this only means that non-bank lenders will also be competing to fill the reduced demand for loans, and the non-bank lending sector is less-vigorously regulated than the banking sector. More-aggressive lending practices from unregulated lenders is not, it seems to me, something we should be encouraging but what do I know? The banks aren’t lobbying me to help level the playing field against the unregulated.
Hopefully this helps illuminate what I have been saying. I think the final chart above would be a lovely final exam question for an economics class, but a bad way to run a central bank. Reality is not so easily charted.
