Browsed by
Tag: volatility

2022 Year in Review

2022 Year in Review

Comments 0 Comment

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

The year in credit (2019)

The year in credit (2019)

Comments 0 Comment

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.

Goodbye Bond King, we hardly knew ye

Goodbye Bond King, we hardly knew ye

Comments 0 Comment

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

Where Leverage Lives

Where Leverage Lives

Comments 1 comment

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

A quick thing on the long-awaited, entirely predictable ‘Volpocalypse’

A quick thing on the long-awaited, entirely predictable ‘Volpocalypse’

Comments 0 Comment

How many warnings did buyers of XIV, the volatility-linked exchange-traded note (ETN) note that went bust last week get? A lot.

First there was the prospectus itself, which spelled out wipe-out risk fairly clearly. Then, there were multiple articles from multiple financial news and analysis outlets, myself included.

There were also tweets!

Like, lots of them!

The below tweet was from Jan. 31st — about five days before the actual blow-up! The only response I got to this at the time was from a guy complaining that he couldn’t see the x-axis so the chart was meaningless. That wasn’t the point! And if you don’t understand what a change in the shape of the VIX futures curve might mean for volatility-linked products, then you probably shouldn’t be trading them!

I tried to sum up just how telegraphed this was in a short note for our markets morning newsletter, which you can sign up for (for free) here.

I don’t mean this to sound callous to those who lost their shirts on this product, but neither do I want this to be spun as a failure on the part of forecasters and journalists etc. This was a well-telegraphed event that people saw a mile coming. That doesn’t mean there wasn’t failure somewhere. The fact that some retail investors seem to have been taken completely by surprise in the recent turn of events suggests they probably shouldn’t have been in these products in the first place. Whether that’s a failure on the part of the regulator, the ETN-issuer, the brokerages that enabled trading in the products, or some other party, I leave that to others to decide.

It’s not just about the VIX

It’s not just about the VIX

Comments 0 Comment

There’s so much talk about volatility right now — and specifically the stubbornly low behaviour of the VIX  — that I thought I’d do a round-up of some of my previous pieces on it.

Please note, I’m in an anti-paragraph, anti-proofreading kind of mood today. So typos and big blocks of text are ahead.

1. On the VIX 

Let’s start with this one, from September 2013, about a new index trying to challenge the VIX, the index that most people associate with ‘volatility.’ For more than two decades, the VIX index run by the Chicago Board Options Exchange has been the financial industry’s go-to method for measuring expectations of volatility in the wider marketplace, with the CBOE turning the index into something of a cash cow thanks to the launch of futures tied to the gauge. VIX-related futures have in turn allowed a plethora of VIX-based exchange-traded products (ETPs) to also launch. With all that money benchmarked to the VIX, it’s no surprise that we have occasionally seen upstarts attempt to challenge it.

2. Selling volatility

Now let’s go here to this story from December 2014. About six years on from the financial crisis and deep in the era of monetary stimulus, investors are struggling to make returns and seize upon the realisation that selling volatility — whether that be through shorting the VIX or some other derivative-based method — can be a lucrative (if risky) strategy. This was the big shift in the volatility market. Instead of having a bunch of banks or hedge funds (or de facto, GSEs) sell volatility, you suddenly have a bunch of buy-side funds and retail investors who are interested and able to do so, the latter largely thanks to the explosion in VIX-related products. The big question, per the piece, is whether these new sellers of volatility are more likely to behave differently than traditional vol-sellers. Are they more or less likely to react to abrupt shifts in volatility?

3. Self-reflexive VIX

By September 2015, the VIX is again in the headlines after the unexpected devaluation of the Chinese yuan spooked markets. While the VIX did jump on this news, it was the VVIX (in effect, volatility of volatility) that reached an all-time record. Here’s my article about that: “When there’s a sudden spike in volatility, as occurred last month, the price of near-term VIX futures rises. Meanwhile, volatility players — notably hedge funds and CTAs — scramble to buy protection as they seek either to hedge or cover short positions, causing a feedback loop that encourages near-term futures to rise even further.” CFTC positioning data at the time did suggest a classic short squeeze as investors closed out their short vol positions post the spike. In effect there were said to be two major forces impacting the VIX, systematic volatility sellers as well as VIX-related ETPs that have to buy or sell futures to rebalance. This rebalancing act makes the VIX curve important, a point picked up on by Chris Cole of Artemis Capital in a story I wrote about a month later: “VIX term structure inverted at the greatest degree in history in August, so much so and so fast that many structured products that use simple historical relationships to gauge term structure switching and hedging ratios just couldn’t handle it,” he said. The concern is that the explosion in volatility-trading means more demand to buy or sell futures to rebalance, which could impact the shape of the curve itself.

4. VIX and beyond!

The proliferation of ETPs tied to the VIX is a concern insofar as it affects the volatility landscape, but it’s not the whole story. To explain, let’s go to Bill Gross, who became the poster child for volatility-sellers after publicly saying in June 2014 — while still at Pimco — that the company was selling “insurance, basically, against price movements” to juice returns in an era of low interest rates. Not once did he mention the VIX. It wasn’t until October 2014, after Gross’s abrupt departure from Pimco, that we got a better sense of what that insurance-selling strategy might mean when the U.S. Treasury market experienced a sudden melt-up, of sorts. At the time, there was plenty of talk that Pimco was liquidating some derivatives positions, which ended up having an outsized effect on the underlying cash market. The U.S. government’s report on the episode later mentioned that: “In particular, anecdotal commentary suggested that some dealers had absorbed a portion of the sizable ‘short volatility’ position believed to have been previously maintained by large asset managers. As volatility spiked on October 15, those positions would have prompted some dealers to dynamically hedge this exposure, exacerbating the downward move in yields.” Then, in August of last year, the BIS published a paper on asset managers dabbling in eurodollars including the example of Pimco in 2014, which I wrote up in a piece called “This is where leverage lives in the system.” That article contained a laundry list of potentially risky strategies across rates (viz eurodollars, futures, forwards), credit (using swaptions and swaps) as well as equities (options, VIX ETPs, etc.). What’s my point? I don’t mean to underplay what’s happening with the VIX, but my concern is that if we’re looking for potential flash points in the financial system then we may want to broaden our horizons.

The year in credit

The year in credit

Comments 0 Comment

Credit markets, I wrote a lot about them this year. One day some other asset class will grab my attention but for the time being it’s this. Sorry.

Here’s what I wrote about the market in 2015 – or at least, since starting the new gig over at Bloomberg in April. I may have missed a few here and there (and included some fixed income posts that I think are related to over-arching credit themes), but I think this is pretty much covers it.

Happy holidays, and may 2016 be filled with just the right amount of yield.

…

Read More Read More

It’s volatile all the way down…

It’s volatile all the way down…

Comments 0 Comment

shortgamma

The surge in volatility trading strategies and volatility-linked products is impacting volatility itself. I was tempted to break out the tail wagging the dog GIF again for this one, but I’ll keep it simple. Read the below, then read this, and this, and this, and so on.

Market volatility has changed immensely

On Aug. 24, as global markets fell precipitously, one thing was shooting up.

The Chicago Board Options Exchange’s Volatility Index, the VIX, briefly jumped to a level not seen since the depths of the financial crisis. Behind the scenes, however, its esoteric cousin, the VVIX, did one better.

For years, the VIX has been Wall Street’s go-to measure for expected stock market volatility. Derived from the price of options on the S&P 500-stock index, the volatility index has evolved into an asset class of its own and now acts as a benchmark for a host of futures, derivatives, and exchange-traded products to be enjoyed by both big, professional fund managers and mom and pop retail investors.

The dramatic events of last month underscore the degree to which the explosion in the popularity of volatility trading is now feeding on itself, creating booms and busts in implied volatility. Even as the VIX reached a post-crisis intraday high, the VVIX, which looks at the price of options on the VIX to gauge the implied volatility of the index itself, easily surpassed the levels it reached in 2008.

Analysts, investors, and traders point to two market developments that have arguably increased volatility in the world’s most famous volatility index, beginning with the rise of systematic strategies.

It’s a week after this was published and the Vix has since been collapsing after shooting up to that August 24 high.

The Tarf Barf

The Tarf Barf

Comments 0 Comment

Hi, Mr. Chief Financial Officer of Generic China Corp. This is John Doe from sales at Solidly Second-Tier Bank. How are you? Listen, I think I have something that might interest you. Ever heard of a Target Redemption Forward? No? Let me explain. It’s a structured product, kind of like a series of exotic options that pay a monthly income as long as the spot yuan exchange rate remains above the strike price. Now, I hate to mention this, but I want to be up front with you, because you know I value your business. The risk here is that if the yuan falls below a certain level—say, 6.2 against the dollar—the option gets knocked out and you have to pay out double the amount. I personally don’t see that happening any time soon. I mean, with USD/CNH trading in this kind of range, we’re talking practically no-risk money.

You’re in? Great!

You already know how this ends (in tears and delta hedging).

Read about the latest slaughter in structured product land over here.