2022 Year in Review

2022 Year in Review

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This blog spent most of the past 12 months being completely neglected. I’m going to blame that on the fact that 2022 was a big year of change for me. I moved back to the US following more than five years abroad – first in Abu Dhabi and then in Hong Kong. I’m now focused on Odd Lots full-time along with my cohost Joe Weisenthal. I’ve also been busy renovating a big old rambling farmhouse in Connecticut on the side, and have learned a bunch of new things like plastering, painting, maintaining a koi pond (!), gardening, and how to maintain a coal stove.

That said, I wrote quite a bit in 2022 as there really was no shortage of financial news flow. It was a year of incredible pain for investors in the face of higher inflation and surging interest rates, plus all the uncertainty caused by Russia’s invasion of Ukraine. Things that did well in the low interest rate years after the financial crisis, quickly saw their fortunes reverse.

Below I’ve included some of my favorite written work of the year, as well as some of my favorite podcast episodes. There are a lot! In an effort to make the list a bit more manageable, I’ve grouped the articles by theme. Thanks to everyone who read and listened to Odd Lots in 2022, and here’s to another big year!


Market pain

The Bubble Portfolio Is Getting Absolutely Crushed (May 10, 2022)
This post pretty much encapsulates the year for me. As interest rates rose, all the things that had been wildly successful in previous years seemed to go into reverse. A hypothetical bubble portfolio, filled with the frothiest of assets (think Tesla, Bitcoin, long bonds and more) was absolutely crushed. As the piece notes, for years, one way to get market-beating returns was to run towards assets with the highest prices. That is decidedly no longer the case.

Bonds

JPMorgan Is Worried About Who’s Going to Buy All the Bonds (Oct. 3, 2022)
I find the debate over whether there is a structural lack of demand for US Treasuries to be absolutely fascinating. It’s one I’ve written about for a while and appears to be heating up again in the context of geopolitical risk (see also Zoltan Pozsar episodes of Odd Lots below) and inflation.

An AA+ Rated Government Bond Down 55% Shows the Pain of Higher Rates (March 30, 2022)
You could have written these types of posts about any number of asset classes this year, but the fact that these types of extreme moves are happening in government-issued bonds is pretty remarkable and demonstrative of the power of duration risk (see also the long bonds in the bubble portfolio).

Goldman Sees a Big Change Coming to the Bond Mark (Feb. 14, 2022)
A simple post but one that, with the benefit of hindsight, was full of alpha-rific predictions such as “while it would be easy to argue that this is all about bonds, it’s not hard to see how this could impact stocks given that Treasuries act as the risk-free rate off which a variety of risk assets are priced.” The yield on the 10-year Treasury was 1.98% when this was written! Worth the price of an Odd Lots subscription IMHO.

Bond Markets Around the World Are Flashing a Warning About Global Recession (Nov. 28, 2022)
I still think there’s a big question mark around how much information you can glean from bond prices in the modern financial system, but prima facie, this post makes the point that bond markets around the world appear to be pricing in various shades of economic contraction.

Cracks in credit

A $10 Trillion Market Has a Big Interest-Rate Shock Problem (Feb. 10, 2022)
This piece laid out, pretty early in the year, the stress that later would come to the market for corporate bonds. Many companies sold bonds with longer terms and at lower spreads, resulting in investors taking on what’s known as duration risk, or higher sensitivity to interest rates. This means that when benchmark rates rise, investors in investment-grade corporate bonds are typically vulnerable to big drops in value.

A Mark-to-Market Massacre Is Claiming a $10 Trillion Market (Nov. 2, 2022)
This piece uses an illustrative portfolio of investment-grade bonds to show just how painful the dynamic described above ended up being for investors. The important thing to note here is that these are mark-to-market losses, and investors in the debt will still get their principal and interest payments so long as the bonds don’t default and as long as they don’t sell them and crystallize their losses. But unfortunately with hardship withdrawals from pension funds hitting a record this year, a lot of retail investors are probably being forced to sell at exactly the wrong time.

A $1 Billion Junk Bond Down 38% in Less Than a Year Shows How Much the Market Has Changed (July 5, 2022)
The above deals with investment-grade bonds, but if you wanted to see extreme mark-to-market moves on something a little riskier, take a look at this $750 million issue from payday lender Curo. This was first issued in July 2021 and reopened in November that year. In the space of just seven months (!) the bonds fell 38%. And if you’re wondering how the bond’s doing currently … it’s now down about 55%!

Junk-Rated Bonds Just Aren’t Behaving Like They Used To (Dec. 15, 2022)
It’s been a bad year for credit from a mark-to-market perspective, but not so much in terms of defaults. As this piece points out, the trailing default rate for junk-rated bonds remains historically low. A lot of that has to do with the fact that many companies spent the past couple of years terming out their debt at ultra-low interest rates, but I also think the Federal Reserve’s corporate bond-buying program has had perhaps under-appreciated impact here (see “One Sign That the Fed Changed Everything in Corporate Bonds.”)

The Fed

The Shadow Is Born: How the Fed Helped Spawn a $23.7 Trillion Market (Nov. 7, 2022)
Based on the research of Josh Younger, this is easily one of my favorite things this year and it also inspired two episodes of the Odd Lots podcast (see list below). We tend to think of the shadow banking system as something that sprang up by accident, but it was actually the result of a series of policy choices — some of them aimed at fixing issues which are very familiar to us today (things like inflation and bond market volatility). I loved writing this piece and the illustrations to go with it. I think you’ll love it too!

The World’s Most Important Market Has a Big and Repetitive Problem (June 14, 2022)
Speaking of bond market volatility, here’s one an ongoing concern in the US Treasury market. Opinions tend to be divided on whether this is a structural issue, or just reflective of big changes in investors’ opinions of the outlook for interest rates. Still interesting to see these big moves happen though.

It’s Official: The Fed’s in the Red (Oct. 10, 2022)
No one’s immune from mark-to-market portfolio losses — not even the US central bank. 2022 saw the Federal Reserve post its first operating loss in years after interest rates soared and demand for US bonds craters. Of course, there’s a vibrant debate about what it means for a central bank with its own printing press to post a loss, more on that below!

Why the Fed Losing Money Might Actually Matter for Monetary Policy (March 15, 2022)
As alluded to in the above, the Fed can’t really go bankrupt. But it can record losses that lead to embarrassing and potentially distracting questions from Congress. It could also change the speed and shape of central bank’s quantitative tightening (QT) to try to perhaps minimize some losses….

Analysts Are Warning That the Fed Faces a Tricky Early Exit From QT (Sept. 12, 2022)
This post picks up the above theme to contemplate potential changes to the Fed’s planned QT program. At issue is the possibility of the financial system falling below a desired level of liquidity, as measured by the amount of reserves sloshing around the banking sector. While the Fed wants to draw liquidity, it doesn’t want to take out too much too soon and put unnecessary strains on the financial system (see the below on the discount window). One thing worth noting, at the time of writing reserves totaled about $3.28 trillion — or about $1 trillion away from the $2-2.5 trillion level that the Fed estimates as ‘ample.’ Now, we’re even closer to that threshold at about $3 trillion.

Billions of Dollars in Fed Discount Window Suggests All Is Not Well in Banking (Dec. 19, 2022)
Speaking of strains in the financial system, we closed out the year with something of a banking mystery. Use of the Federal Reserve’s discount window has been picking up. The question of course is why? While the Fed has been trying to destigmatize this type of emergency lending, it could nevertheless point to some latent issues with a few banks (perhaps related to some recent crypto developments!)

Leveraged Loans

There’s a New Recession Canary in the Coal Mine, Morgan Stanley Says (Aug. 30, 2022)
Since junk-rated bonds aren’t really behaving like they used to, we might have to look elsewhere for signs that credit investors are anticipating recession. Morgan Stanley reckons we should be looking at leveraged loans, and I’m inclined to agree. It’s no secret that leveraged loans have been one of the frothiest areas in finance in recent years, and so it makes some sense to look at them for first signs of cracks in credit.

Wall Street Is Souring On Its Favorite Product for Rising Rates at a Pretty Weird Time (April 21, 2022)
It is pretty funny though, that one of the things that was most pitched as protection against rising interest rates is now seen as one of the most vulnerable to them. This piece outlines how Wall Street spent years touting leveraged loans and their floating-rate exposure as a big beneficiary of rising rates — a pitch which attracted billions of dollars worth of institutional and retail inflows — only to sour on them once benchmark interest rates actually began rising.

Retail Investors Could Soon Dine on Wall Street’s CLO Leftovers (Feb. 25, 2022)
Speaking of retail inflows to leveraged loans, here is more on that theme! As demand for collateralized loan obligations (CLOs) fell off a cliff this year, Wall Street came up with a plan for its CLO leftovers; selling the underlying loans to ETFs beloved by individual investors!

Inflation and inventories

What the Great Mayonnaise Inflation Mystery Can Tell Us About Prices (Aug. 11, 2022)
In 2021, I went down a rabbit hole examining whether the price of mayonnaise had been going up. This post picks up the theme, using the example of mayonnaise to explore how we actually measure inflation. It’s absolutely fascinating to me that price changes of a single condiment — a staple of restaurants, pantries and lunchboxes across America — can be so slippery to pin down. Inflation is always and everywhere a subjective phenomenon.

Investors Are Loving Companies That Increase Their Prices (Feb. 9, 2022)
This post uses two different companies — Chipotle and Clorox — to talk about how investors are reacting to companies passing through higher input prices to customers. Unsurprisingly, they rewarded the company passing costs on (Chipotle) and punished the one that didn’t (Clorox).

Suddenly Investors In Retail Need To Learn More About Accounting (May 25, 2022)
One other way of thinking about how investors have respodnded to inflation, is to consider how they treated companies with inventory build-ups in recent years. Companies that bought a lot early (presumably at cheaper prices later on) probably did well in recent years. But now, as the economy softens, those inventories turn from an advantage to a liability. This post looks at how companies actually account for changes in inventory.

My favorite type of Beveridge

A New Type of Beveridge May Explain a Stubborn Labor-Market Mystery (Sept. 27, 2022)
I’m not that big on economic theory but I do find the debate over things like the Beveridge Curve (and it’s more famous cousin, the Phillips Curve) interesting and important in the context of whether or not the Fed can engineer its proverbial soft landing. This working paper presents a novel new way of interpreting the Beveridge Curve’s post-pandemic shift and implies that a soft landing is possible, but perhaps the most intriguing bit is the bit about mismeasuring actual vacancies. See also, this edition of the Odd Lots newsletter, which talked about another paper on the Beveridge Curve taking an opposing view.

Fed Study Says It’s Solved the Murder Mystery of Who Killed the Phillips Curve (May 24, 2022)
Everyone loves a good murder mystery and I am no different. This post has my favorite economics subhead of all time: “It was the loss of worker bargaining power in the drawing room with a knife.”

Crypto

Barclays Warns Even Fully Collateralized Stablecoins May Be Prone to Downwards Spiral (May 19, 2022)
This post gets my vote for the most relevant for 2023. The Terra/Luna implosion of April 2022 wasn’t exactly surprising. There were a lot of people who had been pointing out vulnerabilities in the algorithmic stablecoin model (we interviewed one of them on the podcast) but even fully collateralized stablecoins have issues. Notably, Tether’s redemption structure may make it prone to preeumptive runs.

Why We Should All Be Talking About the Luna Losers in Terra’s Implosion (May 18, 2022)
This post makes a simple but important point about cryptocurrencies. You don’t hear about the losers. Crypto is full of survivorship bias, with many coins that were in the top 10 by market value subsequently falling into obscurity. It’s also why all those charts of the value of the crypto market kept going up – so long as you can attract more inflows into the new coins, it doesn’t matter if the old ones go belly up.

The Crypto Market Cap Merry-Go-Round Meets the Magic Money Box (Nov. 14, 2022)
This post picks up the point about crypto market cap following the collapse of Sam Bankman-Fried’s FTX. What’s interesting here is that Serum and FTT — the two tokens said to have been used by SBF to secure loans — were never major coins according to market cap. So how can two tokens that don’t even crack the top 100 end up worth more than $10 billion on FTX’s balance sheet? SBF described the exact dynamic in the now infamous ‘Box’ episode of Odd Lots. FTX could issue vast amounts of its own tokens and hold many of them on balance sheet, while valuing them based on a sliver of free float that it seems to have been actively pushing up via Alameda Research. (See also, some of the newsletters below).

Random but good things

What the Heck Is Happening With Elon Musk’s Twitter Stake Disclosure? (April 5, 2022)
One of the big stories this year was Elon Musk’s investment and subsequent takeover of Twitter. I didn’t cover this very intently but could not resist doing a little post on the weirdness of how he went about buying and disclosing his investment stake. There’s a reason why these disclosure rules exist (which you can read about in the above). But of course, we’ve since learned ad nauseum that Musk doesn’t care all that much about following the rules. Since this post, the SEC is reported to be investigating.

How a Semiconductor Shortage Can Impact the Supply of Gummy Bears (Dec. 22, 2022)
One of my favorite things about examining supply chains is the surprising relationships they can sometimes turn up. I wrote last year about how the 2008 bursting of the housing bubble led to a shortage of sawdust, which in turn led to higher milk prices. This is another example of an unexpended connection between two things that at first seem extremely unrelated. It’s only when the economy gets a big whack of disruption that this hidden web of supply chain relationships starts to reveal itself.

Big Mac Prices Show the Pain of the Dollar Doom Loop (Sept. 27, 2022)
The Big Mac is both a symbol of American soft power and hard currency dominance. Since 1986, it has also been a way of measuring purchasing power parity, or the degree to which one country’s money can buy the same things as another country’s currency. In 2022, as the dollar soared to the highest in decades, the greenback as measured in McDonald’s burgers looked massively overvalued.

The UK Is Really Trading Like an Emerging Market Right Now (Sept. 23, 2022)
The gilt crisis? This was just a quick post made on the day of the big selloff in gilts but looking back, the surge in UK government bond yields combined with the plunge in sterling was pretty remarkable to see in a G7 market. I also love the kicker quote from Paul McNamara: If it was an EM you’d be reading it the last rites. But it isn’t.”

There’s an Unusual Thing Happening in the Housing Market (Sept. 16, 2022)
Housing was weird in 2022! At the beginning of the year, Joe and I recorded an episode about just how crazy the US real estate market had got – with stories about competing bids and people being gazumped and so on. Less than a year later and we were talking about the prospect of a housing crash. As this piece notes, the weird thing about the housing market right now the degree to which a fall-off in activity is protecting prices from a really big fall. As the piece notes, the key question for housing-watchers is whether the absolute level of inventory will turn out to be more important than its rate of change.

One Corner of the Trucking Market Suggests the Economy Is Slowing (May 9, 2022)
Joe and I went to our first trucking conference courtesy of Freightwaves this year. It was a blast and I enjoyed putting together this piece after speaking with a number of participants. While the slowdown in freight and the fall in rates has since been well-flagged, it feels like the big question is whether this is more the result of a cyclical build-up in overcapacity or a drop-off in real world economic activity.

Some Companies Are Now ‘Requalifying’ Their Old Bonds as Green (March 18, 2022)
I remember people accusing me of being too negative on ESG. It feels like this year has seen a shift in attitudes and more people have come around to my way of thinking. ESG is incredibly important for the future of the planet and our population, but unfortunately it has been rolled out without any real thought as to what it’s trying to accomplish. In any case, here is a story about companies reclassifying old bonds to ‘green’ or ‘ESG’ that gets to some of that issue. If you think ESG is more about allocating money to green projects, then ‘requalifying’ older debt that wasn’t originally issued with the express intention of funding specific green or social goals might seem strange. But if ESG is mostly about showing overall green intent, allowing the company to advertise its social credentials as much as possible, then reclassifying older bonds could be an acceptable way of signaling this. The fact that we don’t really know what we’re trying to accomplish here, indicates a pretty big failing in the space IMO.

Here’s Just How Weird Some of Those Russian Bonds Really Are (March 16, 2022)
This is somewhat related to the topic of ESG but it’s also just some good old-fashioned bond documentation geekery. Here’s a peek into the prospectuses for a bunch of Russian government bonds, which in addition to a bunch of risk factors about sanctions, also include some esoteric provisions like alternative payment clauses. These of course were thrown into sharp relief following Russia’s invasion of Ukraine, which sparked a wave of worry over whether the country would default on its debt. But there’s also a big question mark over whether large investors who care about the multitude of values hosted under the ESG umbrella should ever have bought these bonds in the first place.

Won’t Somebody Please Think of the ARK Structured Notes? (Jan. 5, 2022)
I forgot I wrote this. With Cathie Wood’s flagship ARKK down almost 70% in a year, I bet some of those structured notes must have hit their knock-out levels. As much as a lot of Wall Street professionals seem to make fun of Wood, they’re not shy about borrowing her brand to launch these.

Here’s the Buy Case for Stocks on Rising Worries Over Nuclear War (March 4, 2022)
I once tweeted a joke that “I would buy the dip on nuclear winter. If it doesn’t happen, my portfolio will be on fire. If it does, my portfolio will also be on fire.” Here is that tweet in analyst research form.

Newsletter

The weekly Odd Lots newsletter has basically become my safe space for thinking about stuff out loud. It’s the place where I cultivate pet theories and write about things that I am still thinking through. You can subscribe to it here if you’re interested. Here are some of the ones that have stood out to me this year.

Odd Lots Newsletter: This Could Be Crypto’s Lasting Legacy (Dec. 23, 2022)
One of my running themes in recent years has been the idea that people have been increasingly running towards bubbles. We talked about it in an episode with Lily Francus and Kyla Scanlon, about how there’s a sense of nihilism running through a lot of investing nowdays and how many people seem to be making lottery-like high-risk investments. I wouldn’t place the blame entirely on crypto, but I do thing the act of betting on made-up tokens has helped to normalize betting on lines moving up and down.

Odd Lots Newsletter: Forever Blowing Bubbles and Building Boxes (April 29)
This was the first newsletter after the infamous Sam Bankman-Fried ‘Box’ interview. Similar to the above, it talks a lot about people willingly chasing bubbles (or boxes). As I wrote in reference to the old “Forever Blowing Bubbles” song: “If Vera Lynn were singing about bubbles today, the whole thing would probably sound a bit different. Rather than serenading us with light and airy “hopes and dreams” for the future, she might instead do an electronicore chant about putting your money in the box.

Odd Lots Newsletter: The Real Problem With Crypto (Nov. 11, 2022)
The collapse of Sam Bankman-Fried’s FTX as explained through the medium of Beanie Babies.

Odd Lots Newsletter: The World’s Supply of Safe Assets (April 1, 2022)
This was based off our interview with Eclectica’s Hugh Hendry, and I think he makes a really interesting point that is somewhat similar to Matt King’s thoughts about something big and fundamental changing in market behavior. As Henry puts it, “what happens is when you can conceive of a business as being risk-less, it becomes price-less. You know, there is no upper bound to the valuation of such businesses. And it’s the same phenomena when we had Treasuries yielding 40 basis points.”

Odd Lots Newsletter: It’s Time to Watch China Again (Dec. 16, 2022)
It’s early in 2023, but if I had to choose one thing to watch in 2022, it would be this. Watch what China is doing — not just with its recent easing of Covid restrictions, but also changes to economic policy.

Odd Lots Newsletter: None Of the Big Econ Debates Are Resolved
Actually, maybe this gets my vote for the thing to look out for in 2023? We know that there’s been a boom in private market investing in recent years. By definition, these are not publicly-traded assets and pricing is not nearly as transparent or immediate. I wonder how much pain still needs to filter through to the most illiquid assets.

That Sound You Hear Is a Reshuffling of Global Capital (Oct. 21, 2022)
Odd Lots itself has gone from talking a lot about financial issues to more real world economy ones. I talked a bit about this transition on our recent AMA episode, but to some extent, I think this is reflective of what’s been happening post-pandemic and also a realization that a lot of financial issues tend to get fixed quickly nowadays with central bank intervention (of course, a preponderance of central bank intervention is probably the ultimate non-fixable financial problem). In any case, since there seems to generally be more of a focus on real world problems and shortages, that’s where the money is going.

Odd Lots Newsletter: The Revenge of the Physical World (March 11, 2022)
Speaking of real world problems getting more attention, this newsletter highlights that financial exposure to commodities is not the same as physical exposure. That’s something we learned a lot this year.

Odd Lots Newsletter: It’s a Global Repricing of Risk (Oct. 7)
This is the big reason why this year has been so darn painful for investors. Bonds are the risk-free rate for a wide variety of assets and when they get slammed, so does everything else. Add to that the fact that we’ve consciously built an entire economic system around what’s supposed to be a bedrock of government bonds, and you have the potential for a lot of turmoil. As Odd Lots guest Conor Sen points out: “changing the price of government debt is the primary mechanism for tweaking employment and inflation, which, as we’re seeing, can be at odds with the role of government debt in global financial-asset portfolios.”

The Market Is Changing the Real Economy
I can’t tell if I was right or wrong in thinking that the crypto crash would lead to investors demanding less leverage in the crypto space. I mean, there is de facto less leverage after everything that’s happened this year. I’m just not sure it came about because investors asked for it. In any case, enjoy this newsletter for this particular exchange, which with the benefit of hindsight, is pretty remarkable:

Matt Levine: I am curious just, like, why people thought running 20-to-1 leverage with this model worked and why people let them…

Sam Bankman-Fried: The institutional players don’t necessarily see their whole book … They don’t necessarily know if most of their loans are overcollateralized or not at all collateralized. And the platforms themselves were the only ones who saw their whole books …

Podcasts

Joe and I enjoyed so many of the episodes this year. There are almost too many to gather here but I’m going to do my best. Consider the below a very non-exhaustive list one of my favorites this year.

Benn Eifert On The Mania That Was Even Bigger Than Meme Stocks
Hyun Song Shin Explains Why This Dollar Shock Is So Unique
Why a ‘Broken’ Mortgage Market Is Keeping Borrowing Rates Extra High
Nouriel Roubini Foresees an ‘Ugly’ Mix of the 1970s and the Global Financial Crisis
Jigar Shah Just Became One of the Most Important Players in the Energy Transition
Here’s How Weird Things Are Getting in the Housing Market
What a Bakery Can Tell Us About the Economy Right Now
Zoltan Pozsar Sees a New Dollar Regime. His Longtime Collaborator Disagrees
Transcript: Ezra Klein on the New Supply-Side Economics
Seven Hand-Drawn Helene Meisler Charts That Explain the Stock Market Right Now
Pimco’s Ivascyn Sees ‘Significant Slowdown’ in US Housing Market
Steel Pipes for Drilling Oil Are the New Semiconductors
This Could Be the Start of a Dollar ‘Doom Loop’ Like No Other
The Co-Founder of TheGlobe.com on What a Bursting Bubble Really Feels Like
Bridgewater’s Greg Jensen Warns Markets Are Still ‘Overly Optimistic’
Meet the Hedge-Fund Manager Who Warned of Terra’s $60 Billion Implosion
Transcript: This Is What Happened to the Meme Stock Mania
Pierre Andurand on How We Might Get $200 a Barrel Oil
Sam Bankman-Fried Described Yield Farming and Left Matt Levine Stunned
Transcript: The 1906 Dredging Law That May Be Holding Back the U.S. Economy
Transcript: Why All of Tracy’s Furniture Is Stuck on a Grounded Ship
Zoltan Pozsar Sees a World Of Problems That Money Can’t Solve
Transcript: What Wooden Pallets Have to Do With Russia’s War on Ukraine
Transcript: How Bill Gross Built a Bond Empire—Then Lost It All
Transcript: Here’s How Messy a Russian Bond Default Could Be
Transcript: Michael Lewis on Why the World Is Still Reading “Liar’s Poker”
Transcript: What Happened to the Price of Nails Over the Last 330 Years
Transcript: Afghanistan’s Former Central Bank Chief on the Dire State of the Country’s Economy

Highlights from 2021

Highlights from 2021

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A corgi stares glumly at a Christmas tree.

2021 was a tough one for me personally. I burnt out in the early part of the year and got very sick. Then I somehow managed to break my foot in three places and couldn’t walk properly for months. For someone who was looking forward to lots of October and November hikes around Hong Kong, this was a pretty annoying and unexpected development.

On the plus side, 2021 did mark a major return to writing thanks to the launch of the Odd Lots blog. This means I actually have quite a bit of bylined work to highlight here this year (I’ve grouped it below according to theme). Meanwhile, the podcast itself is going from strength the strength and I think some of my favorite episodes were recorded this year. My cohost, Joe Weisenthal, and I are both hugely grateful to all those who are listening to and reading this content.

Speaking of which, we do have some big Odd Lots things planned for 2022, so stay tuned!

Supply chains

What Pandemic Puppies Can Tell Us About Supply Shortages, June 17
This was my first deep-dive into the bullwhip effect as explained through one of my favorite things: puppies. The bullwhip effect is, IMHO, essential to understanding what’s been going on with the economy and inflation. It describes how small changes in consumer demand at one end of the supply chain can end up leading to big swings in production at the other end. Those swings can get bigger and more problematic as demand and supply struggle to reach equilibrium, leading to repeated supply shortages (or gluts) and wild swings in prices.

Introducing the Chokepoint Economy, When Shortages Start to Matter, Aug. 4
I think this was an important change in 2020/201. The dramatic experience of the global pandemic seems to have taught many policymakers that the relative flow of goods and capital can matter more than the absolute levels. That means ‘chokepoints’ rather than Keynesian ideas of abundance may be a more useful framing for the future direction of the world’s biggest economies, with governments increasingly focused on building up strategic capacity in things like food security, transportation/shipping, semiconductors, etc. (Of course, China has been doing this for years).

What the Semiconductor Shortage Has to Do With Corporate Bonds, Sept. 15
Joe made me write this but I actually ended up thinking it’s a decent analogy. At first glance, the business of selling chips doesn’t have much in common with the business of selling the debt of blue-chip companies (ha). But as the piece makes clear, both those industries are dealing with a problem of how to allocate an asset that’s in short supply and they end up doing it in similar ways.

What the Economics of Sawdust Can Tell Us About Supply Shortages, Oct. 22
One of the difficult things about supply chain disruptions is that they can expose unexpected connections and therefore have difficult-to-predict consequences. The story of sawdust in the mid-2000s is a great example of this kind of unexpected connection. I don’t think many people would have expected a housing bust to lead to higher milk prices.

ESG and oil

What’s Wrong With ESG Investing as Explained Through the Medium of Ohio
First, let me say that the volume of gushing ESG press releases and investment guides far outweighs the amount of critical stuff out there. But what criticisms of ESG you do tend to see, often veer into highly abstract and conceptual territory. This story was an attempt to illustrate some of the biggest ESG drawbacks through a single thing: the great state of Ohio.

Get Ready for the Inflationary Pushback to ESG Investing, July 15
This wasn’t a long or very detailed post but it did end up being very prescient. As gas and oil prices soared in the latter half of the year, there was a lot of hand-wringing over whether or not underinvestment in fossil fuels had contributed to the problem. I don’t think you can blame it all on ESG, but there is certainly a capital markets component here (see below).

Why Surging Oil Prices Have a Lot to Do With Capital Markets, Oct. 18
To understand what’s going on with the nodding oil pumps in US shale country, it helps to look to the gleaming skyscrapers of New York. In other words, there’s a perception that as oil prices go up, it will inevitably attract more energy players who will dig more wells and increase supply etc. But that ignores a big structural break in the energy’s relationship with capital markets after the shale oil boost of 2014/2015. Investors don’t want to see energy companies spend all their money on drilling and exploration anymore, instead they’re asking for buybacks and discipline on spending. It’s no longer about aggressively growing production, but more about preserving ROE.

Inflation

We Need to Talk About the Great Mayonnaise Inflation Mystery
Part of the reason Odd Lots episodes have been so fun this year is because supply chain issues have given Joe and I a chance to go very, very micro and examine individual businesses, industries and even products. In that spirit, here is a deep dive into what’s going on with mayonnaise prices and how they’re actually measured in CPI indices. So come for the insights into how mayonnaise is actually made, and stay for the deep dive into index construction.

Why We Should All Start Talking About ‘Whackflation’
I still think this is probably the best way to look at inflation right now. This is the monetary equivalent of the bullwhip effect described above. It means that prices can be prone to inflationary booms but also deflationary busts if demand suddenly evaporates, or if it becomes clear that businesses have over-ordered. You can see the whackflation idea clearly in lumber prices, which have already gone through a few mini cycles of booms and busts as the market struggles to reach equilibrium.

Lumber prices have been moving through mini cycles of booms and busts

Capital Markets

No, the U.S. Isn’t Being Overrun by Zombie Companies, June 23
Every time the Fed lowers interest rates someone ends up complaining about how the central bank is creating zombie companies, or businesses that aren’t economically viable but are being kept artificially alive. But the idea of zombie companies running amok in the U.S. economy isn’t born out in anecdotes (see for instance, Hertz’s big comeback after filing for bankruptcy last year) or in the numbers (most companies took advantage of ultra-low interest rates to refinance and term out their debt, meaning they’re actually less indebted than they were before 2020) I do think there are important tradeoffs and risks to think about when it comes to central bank stimulus, but keeping zombie companies alive after the worst global pandemic in more than a century isn’t one of them.

One Sign That the Fed Changed Everything in Corporate Bonds, Sept. 13
Following on from the above, it’s important to realize that something big and important did happen in credit markets in 2020. The Fed for the first time effectively backstopped the entire corporate bond market (even without having to actually buy that much of the debt). The downside of this is that market participants rarely forget a new central bank backstop, and there are signs that corporate bond investors have permanently priced this new reaction function in.

When Everything Is a Growth Stock And All Money Is Venture Funds, Dec. 3
What do you get a credit market that has everything? How about billions of dollars of loans at ultra-low interest rates to companies with no income? This is a deep dive into recurring revenue loans, which are based on expected revenue from a company’s service contracts or subscriptions due (aka annualized recurring revenue). One way of thinking about these is that they’re the credit market equivalent of what’s going on in equity markets, where lofty stock valuations are often justified by wildly optimistic earnings forecasts (see also the below piece on the slaughter in growth stocks).

In the Tarantino Market, the Hottest Stocks Are Getting Quietly Killed, Dec. 3
November was a really weird month for equities. On the one hand, the S&P 500 was basically flat. But on the other hand, some stocks were getting absolutely slaughtered. What’s interesting about this under-the-surface selloff was that it hit all the hottest stocks with seemingly little catalyst. Nothing much happened other than retail investors and hedge funds took a breath and decided that those super-hyped growth narratives maybe looked a little far-fetched.

Treasuries

A $21 Trillion Treasuries Mystery Is Bedeviling Global Markets, March 3
Another year, another bout of weird price action in the $21 trillion U.S. Treasury market that forms the bedrock of financial markets and the benchmark risk-free rate. This year, the gap between bid and offer prices for the 30-year hit its widest since the panic of March 2020 (when the Treasury market was also roiled by leveraged players). It was yet another strange move in a market that really isn’t supposed to have this many strange moves.

Treasuries Acting Like Meme Stocks Helps Explain Low Bond Yields, Oct. 14
The other big mystery in the U.S. Treasury market has been the persistent bid for U.S. debt despite all those worries over inflation and looming rate hikes. One possible explanation is that there are just a lot of buyers for USTs right now who aren’t all that price-sensitive. Buyers like big U.S. banks need Treasuries to satisfy regulatory requirements and so on. Another way to think of it, is that the way a financial asset behaves can change depending on who’s holding it.

Accounting

What One of China’s Biggest Developers Can Tell Us About Debt, Sept. 29
“If you want to avoid being seen to cross any red lines, you could simply go dark” is the opening line of this piece on how one Chinese property developer seems to have responded to the country’s recent crackdown on real estate leverage. It pretty much sums it up.

What the Heck Is a ‘Reverse Repo Note’ and What Happened to All of Tether’s?, Dec. 9
Tether’s financial accounts use some odd nomenclature to describe the financial assets that are supposed to be backing their stable coins, including something called a “reverse repo note.” This shouldn’t be confused with a basic “reverse repo,” which is a normal and well-known term in financial markets. No one in the repo market seems to have ever heard of ‘reverse repo notes’ before though.

Arbitrage

There’s a Massive Arbitrage Opportunity in the Plastics Market, July 13
Do you know what a nurdle is? After reading this post about plastic markets you will. The story centres around a potential arbitrage opportunity in the plastics, with polyethelene in the U.S. and Europe trading at a massive premium to prices in China, but it’s mostly about the compounding effect of supply chain disruptions as shortages in one area (shipping containers, refining capacity) end up adding to scarcity of something else (plastics elsewhere in the world). 

A Huge Arbitrage Opportunity Has Just Opened Up in Crypto, Nov. 24
There was a moment this year where you could buy Bitcoin at a double-digit discount to prevailing market prices so long as you purchased from certain Indian crypto exchanges. Of course, the whole incident was pretty short-lived but it does illustrate a wider point about ostensibly decentralized money — it’s really not that decentralized depending on the exchanges and regulations involved (i.e. you can’t necessarily port money from India to elsewhere that easily).

Scoops

Goldman Bankers Beg to Work Only 80-Hour Weeks in Stinging Deck, March 18
In spring of this year, a group of first-year bankers at Goldman Sachs conducted an anonymous survey, formatted the responses into a slide deck (obviously) and then sent it to on to higher-ups. The deck contained a litany of grievances including long working hours, unrealistic deadlines and an overall pattern of declining mental health as first-years grappled with pandemic-related isolation combined with a bumper year for deals. The deck kicked off something of a reckoning on Wall Street as investment banks started competing with each other to better compensate their burnt-out junior bankers, with higher pay, somewhat restricted hours and even Pelotons.

Billions in Secret Derivatives at Center of Archegos Blowup, March 29
This was the first story to draw attention to the type of financial instruments Bill Hwang had been using at Archegos, the $20 billion fund which went spectacularly belly-up in the space of a few days in March. As noted in the piece, Hwang’s use of swaps meant that he could amass big positions in stocks without actually owning the underlying securities. He also didn’t have to provide as much margin to his prime brokers. Since this piece was published, the SEC has proposed new rules that would require more disclosures for swaps and limit how much hedge funds can use them.

Morgan Stanley to Repay Hong Kong Staff $5,100 for Quarantine, Nov. 24
Morgan Stanley was the first investment bank in Hong Kong to announce that it would reimburse staff for quarantine costs, a story which also kicked off a round of competitive offerings from investment banks. The issue of quarantine reimbursement is probably of limited interest to anyone outside of Hong Kong, but it’s certainly been a big topic in a city where it’s now prohibitively difficult and expensive to travel. Hong Kong’s extreme quarantine requirements have very much altered its attractiveness for expat financial workers and fundamentally changed the value proposition of being based the city (by way of personal example, I haven’t traveled outside the territory for more than two years now).

Misc.

Bonds of Power – Lecture for Investor Amnesia’s Imperial Finance: A History of Empires
Putting this lecture together for Jamie Catherwood’s Investor Amnesia series was a lot of work but it also ended up being surprisingly fun. It’s a deep dive into one of my favorite topics — the nature and moral obligations of debt — as explored through the prism of defaulted Russian imperial debt and imperial Chinese bonds. One thing it illustrates perfectly is that because bonds are so often tied up in stories of who owes what to whom, they can end up being surprisingly powerful political tools. (You should also check out some of the other great lectures by Marc Andreessen, Niall Ferguson and Kim Oosterlinck, who has also done some sterling work on the topic of morality and bonds).

The year in credit (2019)

The year in credit (2019)

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I’m a little late to this annual tradition but here it is — highlights from 2019’s collection of credit-related stories. This is by no means a full list of my work this year, but these are the things that I’m thinking about as we enter the new decade.

Did Fed Know What Credit Markets Didn’t? Loan Bankers Get Strict, February 7
It’s easy to forget this now, but in early 2019 the market was all-aflutter over the Federal Reserve’s Senior Loan Officers Survey, which showed banks tightened lending standards over the last three months at the fastest rate since the middle of 2016. The furor died down as banks began easing standards again (though tightening for C&I loans has since resumed) and the Fed lowered rates, but it hints at the amount of concern out there about overheating in the credit market.

Hot Rally Raises Questions of What’s Really Cooking in Credit, March 22
The almost complete recovery in credit markets since the sell-off in late 2018 plus a dovish Federal Reserve helped refocus attention this year on the multiyear boom in corporate debt. That boom means investors are arguably accepting worse deals for less return. For Deutsche Bank analysts, the dynamic has shades of a previous Wall Street boom.

CLOs Are Starting to Look More Alike, Stirring Uneasy Memories, June 11
Another entry for the ‘history doesn’t repeat, but it does rhyme’ category. Rampant demand for leveraged loans has outpaced supply in recent years, leaving CLO managers with a more limited pool of loans from which to create their deals. That means the chance of two CLOs holding the same underlying debt increases so a single soured loan could wind up hitting multiple investors.

Convexity Hedging Beast’ Blamed for Lower Bond Yields, August 19
This isn’t strictly a credit-related piece, but I include it as an example of the reflexivity of markets. It’s very possible that the yield curve inversion we were all worrying about this year was the result of technical forces (convexity hedging), or at least exacerbated by it. That sort of begs the question of whether this kind of technical activity can end up worsening, or event creating, trouble in markets. See also, the VIX exchange-traded product blow-up of early 2018 or the occasional rumblings of a similar dynamic in credit derivatives and the cash market.

Repo Fragility Exacerbated by a Hot New Corner of Funding Market
JPMorgan Warns U.S. Money-Market Stress to Get Much Worse
Odd Lots: Why the Repo Market Went Crazy
Repo Oracle Zoltan Pozsar Expects Even More Turmoil
Repo! A blow-up in the repo market happened this year! Again, this is not strictly credit-related, but turmoil in this crucial short-term lending market can end up impacting dealers’ risk appetite and therefore wider markets. Of particular interest is the role of sponsored repo outlined in the first piece. This is something the Bank for International Settlements ended up singling out as a key catalyst for the troubles.

Old trading docs

Old trading docs

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Last week, MrMacroMarkets tweeted a link to an old documentary on FX trading called Billion Dollar Day. It was amazing, and sent me down a rabbit hole of old trading videos.


Bulls and Bears, 1998 – Follows a group of futures traders in the late 1990s including John “Rambo” Moulton, a sarong-clad American working out of Queensland.


Trader, 1987– Paul Tudor-Jones in the 1980s is peak Wall Street in the 1980s.


Billion Dollar Day, 1985– Follows currency traders in the financial centres of London, New York and Hong Kong. This one is brimming with charming anachronisms


Let’s Deal Direct, 1984– Not a documentary per se but more of an educational advert for Bear Stearns’ mortgage-trading desk, of all things. Features some, umm, questionable acting and dialogue: “Could you use the bonds?” … “Yes sir, I CAN use the bonds” etc.


Black Wednesday, 1997– The BBC looks back at 1992’s Black Wednesday. It’s not quite as swash-buckling as some of the other videos on this list, but it does have some good trading colour from the day the Bank of England intervened in the currency market.

How the Collapse of an Economic Bubble Helped Charles Darwin Prove His Theory of Evolution

How the Collapse of an Economic Bubble Helped Charles Darwin Prove His Theory of Evolution

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(It’s probably not a secret that I enjoy finding examples of economic bubbles. So here’s a pretty obscure one, courtesy of some recent readings on chickens.)

Not many people remember the chicken bubble of the mid-1800s. Variously referred to as ‘The Fancy’ or ‘Hen Fever,’ the movement saw thousands of newly-minted middle class families rush to purchase rare varieties of chicken. Those birds came with wondrously exotic names such the ‘Sultans’ imported from Istanbul, ‘Great Javas,’ or ‘Cochin-Chinas,’ which were rumored to resemble ostriches in their size and feathered legs.


  • From Geo P. Burnham’s ‘The History of Hen Fever,’ published in 1855

Hen Fever reached its height by 1849, with breeding pairs of ornamental birds going for thousands of dollars in modern money at poultry shows. Across the U.S. and Great Britain (Where Queen Victoria’s early passion for a couple of of rare chickens had helped ignite the craze) polite parlours were apparently filled with fluffy-feathered talk of hen breeding.

When the bubble burst in 1855, the prices of fancy chickens plummeted — putting them in reach of one Charles Darwin and a host of competing biologists and theologians. By then, Darwin had returned from his famed trip to the Galapagos and was feverishly incubating his ideas on natural selection.

From Geo P. Burnham’s ‘The History of Hen Fever,’ published in 1855


Armed with wild Red Jungle Fowl from Southeast Asia and a newly cheap and varied supply of domesticated chickens, Darwin was able to show that the wild red birds could successfully breed with ‘fancy’ fowl to produce fertile offspring — suggesting that the modern supply of chickens wasn’t a separate species to its jungle cousins and in fact, had probably originated from it. He argued human intervention through generations of selective breeding likely accounted for the many features found in domesticated chickens, be they an snowy white coloring or feathered legs.

Chickens got short-shrift in Darwin’s famous Origins of Species when it was published a few years later, but they helped him firm up many of his ideas on adaptability and genetics.

It’s worth mentioning here that Darwin’s exact conclusions when it comes to the humble chicken are still being debated to this day — with researchers at Uppsala University arguing that grey jungle fowl also donated some genes to domesticated chickens.

Regardless of how you feel about the humble chicken’s origins, it’s fair to observe that an economic bubble almost contemporaneously described as unsurpassed in “ridiculousness and ludicrousness,” helped provide the raw materials for one of the most important scientific breakthroughs of all time.

For more – check out:

Why Did the Chicken Cross the World? by Andrew Lawler, and The History of the Hen Fever : A Humorous Record, published in 1855, and the source of the above images.

Goodbye Bond King, we hardly knew ye

Goodbye Bond King, we hardly knew ye

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Bill Gross, the erstwhile ‘Bond King,’ has announced his retirement. Over the course of four decades, Gross made his name actively trading bonds and started doing that before those bonds were really even considered things that were actively traded. He co-founded Pimco, then moved to Janus in late 2014 in an abrupt and somewhat drama-filled chapter of market history.

While buckets of ink have been spilt on Gross’s career and legacy, I want to point out two things. The first is that, as the title suggests, there’s still a lot we don’t know about the Bond King’s strategy. While investing in bonds might seem like a straightforward activity, it’s no secret that Pimco augmented its performance with a host of derivatives and ‘overlays.’

See for instance, Zoltan Pozsar’s work on the topic in early 2015, which I wrote up in a column for the Financial Times around the same time:

Reach for returns takes funds into the shadows

… The extent to which low interest rates have driven mutual funds and other asset managers to become entwined with shadow banking is laid bare in a new research paper by Zoltan Pozsar, former senior adviser at the US Treasury.

This shadow banking system has long been described as a network of non-bank financial intermediaries, but it is perhaps better characterised as a reference to a particular set of financial activities.

Classic examples of such activities include financial institutions borrowing money by pawning their assets through ‘repo’ agreements or securities lending transactions, as well as using derivatives.

Traditional notions of shadow banking usually centre on the idea of repo being used to fund the balance sheets of broker-dealers and banks. When entities like Lehman Brothers and Bear Stearns became locked out of the repo market in 2008 they suddenly found themselves starved of financing, triggering an avalanche of stress across the financial system.

Regulators have spent the years since the financial crisis trying to clamp down on shadow banking as they attempt to improve the overall safety of the financial system. Since such activities are rarely associated with traditional mutual funds that invest in bonds and other assets on behalf of large investors such as pension funds and insurers, such funds have rarely been mentioned in conjunction with shadow banking.

Mr Pozsar’s research suggests that is a mistake. For example, a cursory look at the balance sheet of Pimco’s flagship Total Return Fund shows a bevy of derivatives including futures, forwards and swaps. Moreover, its repo borrowings at the end of the first quarter of 2014 stood at $1.12bn. The fund’s subsequent annual report shows repo borrowings for the period averaged $5.73bn — more than five times the amount reported at quarter-end.

Such window dressing is usually associated with big investment banks that cut back on their leverage ahead of quarter ends as they seek to flatter their funding profiles and impress their investors.

Its presence on Pimco’s balance sheet is symptomatic of a long-term trend that has seen mutual funds evolve from staid, largely “long-only” managers into very different beasts. In addition to accumulating billions of dollars’ worth of fixed income securities in recent years, the funds have reached for an alternative financial toolkit of derivatives, securities lending and other forms of leverage, to help boost returns.


Gross was also famously vocal when it came to espousing a short-volatility strategy in mid-2014. Doing so wasn’t necessarily wrong, as Gross noted it was “part and parcel” of an overall investment strategy that rested on sluggish U.S. growth and low interest rates, but it nevertheless raised eyebrows among his peers and competitors who viewed the new crop of buy-side volatility-sellers as tourists in a somewhat dangerous market.

The second point is that the sheer size of Gross’s creation — Pimco — has at times had massive effects on the wider market. “Big West Coast player” means just one thing for many in fixed income, and Pimco was said by plenty of observers to have frequently thrown around its gorilla-esque weight to get favourable pricing and allocation on new bond deals. Conversely, however, the sheer size of the Total Return Fund (which from memory peaked at almost $300 billion), was also said by market participants to pose challenges for its managers, the idea being the fund had grown so large it effectively struggled to beat its benchmarks.

That size could also have more deleterious effects. Few people seem to remember now, for instance, that when Gross left Pimco, it coincided with a noticeable sell-off in inflation-linked bonds and junk-rated paper. Or that the flash crash in U.S. Treasuries in October 2014 was rumoured to have been sparked by a sudden liquidation of interest rate positions favoured by Gross. There are still so many interesting open-ended questions posited by Bill Gross’s adventures in Bond Land, and from that perspective I’m somewhat sorry to see him go.

Anyway, for those interested in mulling these questions more, here’s some previous work — much of it done with the FT’s fantastic Mike Mackenzie:

Gross exit from Pimco tests bond market – September, 2014
Pimco upheaval rattles bond market – September, 2014
Wall St sheds light on Bill Gross reign after Pimco departure – October, 2014
Bonds: Anatomy of a market meltdown – November 2014
Caught on the wrong side of the ‘vol’ trade – December, 2014
Reach for returns takes funds into the shadows – February, 2015

The year in credit (2018)

The year in credit (2018)

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So it’s been a while and I don’t write as much as I’d like to anymore, but given the amount of current interest in the credit market I thought I’d put this here.

Market Selloff Played Out in the Most Hidden Corners of Credit
If you read one thing about credit this year, please make it this. Something you hear in the market quite a bit is that ‘X’ or ‘Y’ won’t be a huge problem because we don’t have as much leverage embedded in the financial system as we did in 2008. Back then, subprime mortgages got bundled into Triple A-rated bonds that then became the subject of all sorts of derivatives bets which then helped amplify the downside across the financial system. While it’s very probable we are nowhere near that scale when it comes to corporate credit, there is an added layer of leverage that doesn’t get nearly enough attention.

How February’s market sell-off played out in corporate credit is a useful example of this concern. The selloff arguable took place not in the cash market, but in derivatives attached to it including CDX indices and options on those indices. More worryingly, there is a concern among some market participants that those options end up having an impact on the underlying indices themselves during intense bouts of market action. Dealers have to rush to hedge as those price movements cause options to expire, exacerbating the price movements and potentially causing further pain. The point to all of this is that there’s a complex ecosystem of credit exposure that, I would argue, we do not have a very good understanding of.

(As an aside, we’ve seen negative gamma-sparked bouts of market volatility a couple times this year in different asset classes, including the VIX product blow-up and — somewhat more randomly — the oil market. Unfortunately, the Oxford Dictionaries declined my nomination of gamma as word of the year.)

Some other things worth reading:

Goldman Says Riskiest Junk Bonds Are Most ‘Mispriced’ Since 2007
Do you know a special someone who likes to say that “corporate credit’s a good buy so long as defaults remain low?” This holiday season get them this note from Goldman, in which the bank lays out that its “preferred valuation measure of corporate credit, which subtracts their projected expected-loss rates from current spreads, shows U.S. high-yield obligations are now mispriced for even the most benign [default] scenarios.”

Goldman Warns of Liquidity-Fueled Sell-Off After ‘Volmageddon’
From the guys that brought you “liquidity is the new leverage,” comes this piece warning that low liquidity may not be isolated to the corporate bond market but could be a problem across the broader (equity) market. You can quibble about the meaning of liquidity in this context, but I think the point is that the market is susceptible to sudden and dramatic pullbacks as *everyone* changes direction at once. See also the two items below.

It’s Not Just Italy. Shock Moves Jolt All-Or-Nothing Markets
Another way of saying this is that in this market, everything is fine until it isn’t. Assets can be priced for perfection and many red flags ignored until everyone suddenly rushes to the exits. The catalyst isn’t necessarily a change in the fundamental outlook for the asset, but a change in investor behavior. “The binary ‘all-in/all-out’ behavior, which up until now was relegated to the fringes of the financial markets, has gone mainstream,” says Peter Atwater. (There’s a bonus Galbraith’s ‘Bezzle’ reference here too).

This Is What Happens When Markets Stop Chasing Flows
On a completely related note – this is one of the defining features of post-crisis markets in my humble opinion. Investors used to chase assets until they became ‘overvalued,’ at which point the inflows would stop. But in a market characterized by sluggish economic growth and low yields, the way to generate outperformace was not by identifying assets with the most return potential based on fundamentals, but those most likely to attract other investors. Because you’re chasing flows and not fundamentals, the market is no longer self-limiting. In other words, there’s no natural place for asset valuations to stop so long as inflows continue. This story is terminal-only but you can read a similar argument over here.

Odd Lots: What David Barse Learned From Watching A Credit Fund Blow Up
The last major hiccup in credit markets took place in late 2015, when Third Avenue Management blew up. So it’s worth listening to the thoughts of the former Third Avenue CEO on this episode, even though you may not agree with them. (Also, please subscribe to Odd Lots. I often stay up until 11pm to make these and I like to think some people are profiting from my sleeplessness!)

Citi Warns U.S. Credit Locked in a Losing ‘Internecine’ Battle
If you think your BBB-rated bond is priced for perfection, what if it’s not really a BBB bond? There’s no denying that a huge chunk of the corporate credit market has migrated to the middle of the ratings bracket in recent years which suggests there is, by definition, some there is a lack of credit differentiation compared to previous years. In any case, it’s interesting to see different analysts pegging different ratings ‘buckets’ as the problem. Most people seem worried about BBB but there are others singling out the single As, for instance (ha). Here’s Citi: “An environment in which one single-A credit can be carted out into single-B spread territory almost overnight is perilous to ratings-constrained institutional investors, particularly in Asia, that have chased the yields of blue-chip U.S. debt into the low-A/mid-BBB territory.”

Fate of $1 Trillion in Risky U.S. Loans May Be in Japan’s Hands
Speaking of Asia, it’s usually not a good sign when the market starts looking for the bagholders but in this case you could do worse than Japanese banks, typically viewed as long-term buy-and-hold investors. Watch those FX hedging costs, that BOJ monetary policy as well as dealer activity, though. To bring everything here full-circle – It’s yet another example of complex interplay in credit markets. A bunch of these deals have been done through so-called repacks – meaning there’s typically a currency swap agreement done with another (often European) bank. So the market needs to worry about an extra layer of FX sots and dealer risk appetite/balance sheet, in addition to the underlying ‘health’ of the credit market.

Bye bye Abu Dhabi

Bye bye Abu Dhabi

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After two years it’s time to say goodbye to Abu Dhabi and take on a new adventure. I’m grateful for an experience that allowed me to meet and interview oil ministers, billionaires, and politicians. I got to break news on the downfall of Abraaj — once the Middle East’s biggest private equity firm — and cover the transformation of Adnoc — the U.A.E.’s giant national energy company — under CEO Sultan Al Jabar. I analyzed OPEC’s production cut agreement, dug into the actual nuts and bolts of the oil market, and watched decades-old trading routes be redrawn in an era of lower energy prices. I met sheikhs and royals (book-endeding a busy conference season by shaking hands with Saudi Crown Price Mohamed bin Salman and then former U.S. President George W. Bush). I learned how best to serve kibbeh nayyeh and can tell you where to find the best cardamom-flavoured tea. I made memories, friends and an extremely unsuccessful attempt at learning Arabic (don’t miss my one and only Arabic joke). I was asked multiple times if my name was Al-Ouwei. In short, I learned and did a whole lot.

Yalla, bye.

About Abraaj…

About Abraaj…

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Here in the U.A.E. the big news has been the swift and sudden collapse of Abraaj, once the Middle East’s biggest private equity firm and an erstwhile ‘success story’ of Dubai’s financial centre. Headed by the charismatic Arif Naqvi, the firm had $14 billion of assets as recently as a year ago. Now it’s in liquidation following accusations from international investors including the Bill & Melinda Gates Foundation that it mishandled money in a $1 billion healthcare fund. Early reports from the liquidators describe even more questionable behaviour.

If you want to know more about what’s shaping up to be the biggest PE collapse in history — then try the following links to a couple Bloomberg long-reads from myself and a couple of awesome Bloomberg colleagues: Dinesh Nair and Matthew Martin.

The Downfall of Dubai’s Star Investor — June 14, 2018

Behind the Spectacular Collapse of a Private Equity Titan — July 30, 2018

You can also check out the below clip (about 38 minutes in), from Bloomberg TV’s What’d You Miss?, where I put the whole Dubai-based drama into an international context:

Where Leverage Lives

Where Leverage Lives

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I was thinking about the recent volpocalypse and some of the action we’ve since seen in the credit market, where February’s big market ructions played out in credit derivatives as opposed to the cash corporate bond market. That’s not entirely surprising given that the cash market has long been said to be less liquid than its synthetic counterpart, but what is rather concerning is these are largely derivatives tied to credit indices and there’s the potential for a self-fulfilling feedback loop similar to what we arguably saw in VIX-related products and the Volatility Index itself. Overall, there are huge pockets of leverage in the system, from run-of-the-mill equity options used to eke out excess returns, to more esoteric credit derivatives like CDX options.

Anyway, it put me in mind of the below piece from a couple years ago.

—-

This Is How Leverage in the Financial System Lives On

By Tracy Alloway

(Bloomberg) — Rumors of leverage’s death have been greatly exaggerated.

In the aftermath of the 2008 financial crisis an abundance of leverage — borrowed money used to amplify returns — was blamed for exacerbating losses on subprime mortgages and contaminating the banking system with catastrophic results. Since then a host of new rules have been enacted to reduce financial leverage, including penalizing certain derivatives positions, such as the credit default swaps (CDS) villainized in the crisis, as well as outright curbing the amount of borrowing allowed at big banks.

While such efforts have made substantial steps in derisking the financial system — especially at large lenders — they’ve also encouraged the creation of new types of leverage and its migration to different players. Today, much leverage appears to sit on the balance sheets of large and small investors, often fueled by the need to generate returns amidst ultra-low interest rates and high correlations that see asset classes move together and make it more difficult to produce outperformance, known as ‘alpha.’

Leveraged strategies may include selling volatility or dabbling in derivatives tied to interest rates or corporate credit. While few are suggesting that the leverage deployed via such tactics could cause a crisis on the scale of 2008, it can create unexpected consequences ranging from a ‘flash crash’ in one of the world’s most liquid markets to constraints on the Federal Reserve’s ability to change monetary policy, as highlighted by a new paper from visiting professors at the Bank for International Settlements.

Moreover, they underscore the risks facing the market as investors continue to divide themselves between those eschewing the chance to earn a steady stream of returns by betting big — and those willing to risk the chance of outsized losses in the event of a significant change in markets.The latter group found a posterchild in the way of Bill Gross, the former co-chief investment officer of Pacific Investment Management Co. (Pimco) and erstwhile ‘Bond King’ who spoke publicly about his use of derivatives to increase returns in the “new neutral” era of ultra-low interest rates, shortly before departing the company in late 2014.

Pimco’s flagship bond fund, the Total Return Fund (TRF), sold $94 billion worth of put and call options on floating to fixed income swaps, or 41 percent of the fund’s net asset value, according to BIS data. Known as selling or shorting volatility, the strategy allowed Pimco to collect insurance-like premiums as long as interest rates stayed low.Similarly, Pimco deployed eurodollar futures, a type of derivative that locks-in interest rates for investors, with long eurodollar contracts at the Total Return Fund (TRF) jumping from 250,000 in March 2013 to almost 1.2 million as of June 2014.

While Pimco noted at the time that such long eurodollar futures contracts were “used to manage exposures at the short end of the yield curve and express PIMCO’s expectations for short-term rates,” they also come with the benefit of added leverage, in effect boosting returns so long as rates remained low.

Gross’s departure from the fund in September 2014 sent the TRF’s managers scrambling to liquidate the eurodollar contracts as investors redeemed their money. The liquidation may have exacerbated the flash rally in U.S. Treasuries that took place shortly after, when the yield on the benchmark 10-year note seesawed wildly in the space of a few minutes, the BIS paper said.

“The irony is that a more measured pace of liquidation would have allowed the fund to profit from the bond market ‘flash rally’ of October 15, 2014,” visiting BIS professors Lawrence Kreicher and Robert McCauley wrote in the paper. “In any case, it appears that a huge long eurodollar position could be and was liquidated in a fortnight. By contrast, [the TRF’s] liquidation of its ‘short volatility’ position may have contributed to the ‘flash rally,'” by setting off a wave of hedging amongst dealers who scrambled to absorb Pimco’s short position.

The use of eurodollar futures has not been confined to the world’s erstwhile biggest bond fund, with the BIS paper noting that while asset managers play a diminished role in day-to-day trading, they “generally hold the largest eurodollar positions among buy-side participants.” Their “dominance in positioning establishes them as gatekeepers for the Fed’s forward guidance” limiting the U.S. central bank’s ability to change monetary policy if asset managers are not positioned accordingly — as seen in the 2013 taper tantrum.

Investors seeking to boost returns at a time of abundant liquidity and unconventional mo

netary policy have also applied leverage to corporate credit, a market which has exploded in size thanks to low interest rates and yield-hungry investors who have enabled companies to sell more of their debt. While the use of single-name CDSs that offer insurance-like payouts to a single security, company, or government, has diminished in the wake of the financial crisis, trading tied to indexes comprised of multiple entities has jumped.

With corporate default rates at historic lows and with stimulus increasing correlation between asset classes, use of so-called CDS indexes has boomed as both a trading and hedging tool, allowing investors to create an “overlay” on their portfolios to protect against a systemic rise in defaults at a time when liquidity is said to have deteriorated.

Further complicating matters is the explosion in alternative derivatives or ‘derivatives of derivatives,’ with investors now served an expansive menu of exotic synthetic credit products including options on total return swaps (TRS), options on CDS indexes, and a suite of other bespoke offerings.

Such ‘swaptions,’ as they’re sometimes known, give investors the right to buy or sell the index at a particular date and for a certain price, and are said to have surged in popularity in recent years. Analysts at Citigroup Inc. estimated that about $24 billion of CDS index options traded in 2005, rising to $1.4 trillion in 2014 — a more than a 5,000 percent jump in activity in just under a decade.

Strategists at Barclays Plc have expressed concerns that the rapid rise in CDS index option volume was impacting the underlying index, while a senior credit trader at one of the biggest banks told Bloomberg earlier this year that the notional volume of credit index options traded has on some days surpassed the volume of trades in the referenced index. A more recent survey by Citigroup Inc. analysts earlier this year showed 72.6 percent of investors expressed concerned over how “investors are taking more leveraged risk using derivatives.”

In the equity market, a jump in the number and amount of products tied to the Chicago Board Options Exchange’s Volatility Index, the VIX, are sometimes said to be impacting the index itself. While the VIX, which is based on options contracts tied to the S&P 500, remains far below its financial crisis highs, volatility of the index itself last year reached an all-time record.

This is how leverage in the financial system lives on – Bloomberg, August 2016
Market selloff played out in the most hidden corners of credit – Bloomberg, February 2018