Monday, May 2, 2016

- A Useful Trade Idea

I can't remember the last time I did this, but what I have written here is a trade-able investment idea. I think we've found all the missing inflation that has hobbled central banks for a decade or more.

I find this piece by Economist Robert Blumen, deeply persuasive, but I don’t think it much matters. A basic translation of it for non-economists is this:

The derivatives market has provided artificial demand for Treasury bonds, and has in that manner kept inflation low in spite of the Federal Reserve and other national reserve banks selling mountains of government guaranteed debt. We only see wage and price inflation as that money flows through traditional channels into productivity activity, but the Derivatives market’s artificial demand for underlying assets has instead given us unjustifiably high equity prices, an explosion of basically useless tech startups, and other highly leveraged investment vehicles.

Connecting the dots may seem a little unclear to the uninformed reader, but as a guy who made his living in the derivatives markets for most of his career, I can tell you that I believe this assertion to be unambiguously true. It may be conjecture as stated by Blumen, but it is reasonable conjecture that perfectly matches the circumstances we currently find ourselves in and reflects all the nuances that accompany our increasingly complex financial markets.

And I don’t think it matters at all.

Some may react with horror at that. “You mean to tell me that Hedge Funds are keeping the Fed’s one tool for managing inflation from working and you don’t think it matters?! The entire financial market is broken and you don’t care? What are you some kind of monster?!” (That last sentence is placed at the end of most of my assertions by someone at somewhere on the left of the spectrum, so I do it here out of habit.) But the reason it doesn’t matter is because it’s not like it’s a decision someone is making. These effects are symptomatic not causative. “Hedge fund profits” aren’t the reason this is happening, they are only the result of this happening. And they ain’t happening much anymore.

Hedge Fund profits have been falling for years, and will continue to do so. But this is because of how hedge funds have always worked. To make money hedge funds used what is called an ‘information advantage’. They learned something better or faster than someone else, reacted to it quickly and prudently, and the result was their profit. But since the markets are now broken, the business model of hedge funds are broken too. It’s taken some time for that fact to work its way through to the people who invest in hedge funds, but it finally has. The result is the billions in redemptions that are currently occurring.

As the hedge fund market space contracts, so too will the leverage that they carry in the derivatives markets. The derivatives contracts they own will be ‘rolled up’ just like selling a position, and less risk will be on the table. The air will come slowly out of the balloon in fits and jerks, as specific funds reduce specific positions. The derivatives were created from nothing, and will return to nothing. But not so the Treasury bonds used for collateralizing them. As they unwind their derivatives books, the funds will likely want to keep their leverage ratios more or less fixed (or at least manage them as a reaction to other market phenomena) so the Treasury Bonds they used to provide collateral, will likely be sold into the secondary market. That increases their supply, which reduces their price, and increases interest rates.

As rates rise, the Fed will try to ‘manage’ that. Our Federal Government is an economic basket case of the first order, and we as a people are profoundly addicted to the services offered by a government that is spending taxes which is has not yet (and is unlikely to ever) take in. Any meaningful increase in interest rates will have catastrophic consequences for the Federal balance sheet so the Fed will have to go and ‘buy’ the debt to keep demand high. The thing they will buy that money with, is what can accurately be referred to as ‘zero duration paper’, otherwise known as ‘cash’.

There is your inflation right there.

There is more to that though. No matter what happens in the financial markets, or in most cases, even with the Federal Balance sheet, the US is still thought of as the best place to store your assets – because it is. It’s a relatively free country with strong property rights and is responsible for 50% of the military spending on the planet. Those guns but a lot of certainty. This makes inflation a global story rather than a national one. Its US Federal debt that is acting as the collateral for all financial assets across the globe, from Japanese stocks the Chilean currency futures. Many of those markets are MUCH more sensitive to global interest rates than the US is. So when the Federal Reserve pushes on the US dollar, the rest of the world is likely to push back. We won’t see domestic inflation until after we begin seeing it elsewhere.

But I believe it’s coming now. And I believe it will be signaled by the rusting away of the Hedge fund world. Watch Hedge Fund redemptions. None of the hedge funds are making reliable and continuous profits high enough to justify a 2 and 20 pricing model so they will see redemption requests. As they redeem investors, their leverage will fall and the ‘printed money’ will find its way into the regular productive market.


the only caveat I have to this (as I'm thinking it through) is the pervasiveness of SPV's assembled by the banks so that their derivative counter-parties could carry off balance sheet derivatives. To my knowledge there is no means of accounting for these products except by the banks themselves, and since the risk they represent to the issuing bank is usually sold off to the secondary market and represent no real risk to the bank, they are not going to be found on any examiners reports.

An SPV is essentially a corporation assembled by a bank and 'purchased' by their counterparty. It serves as a holding company for the cashflows represented by the derived products. I've mentioned them before when talking about the Argentina Energy swap deals I worked on while at JPMorgan. In that case, the SPV amounted to a commitment from Argentina to deliver tankers full of oil over an extended period. And in return they received an up from payment from JPMorgan in the form of a swap which represented cash payments for that oil.

So although this description is of a commodity SPV, the same can be done with debt. In effect, the SPV becomes the equivalent of a Hedge Fund which have the effect of making the assets and liabilities disappears from the balance sheet of both the bank and the derived counter party. The company itself has no operations, and is a paper company only, which is used for managing cashflows. Some credit exposure usually flows through, but is usually quite small when compared to the underlying assets and is usually hedged away.

This might be a big deal, and it might not. It's been a very long time since I worked at an investment bank, so I don't know how common it is anymore. MY instinct is that it will be on the smaller side because there is a substantial cost involved in assembling an SPV, and in my day it was only done as a means of regulatory arbitrage. In the example above, so that the government of Argentina can 'sell it's oil' to a domestic Argentinian company - of which the SPV was one. There aren't nearly as many rules around the purchase of government debt, so I expect the cumulative leverage they represent is minimal.

If the deal mentioned above sounds 'fishy' to you, it wasn't. It was my experience that JPMorgan never even came close to violating the law - ever. Corporate cultures do change, but during my tenure they would sooner turn down a deal than push the envelope. If there was anything at all even remotely 'fishy' about it, you'd have to share that with the Argentinian authorities, and their regulatory body for disposition of mineral rights. You might consider asking them what became of those cashflows (payments) delivered years ago, for oil which (I believe) is still being pumped from the ground today.


VV said...

Good point Tom. I have been watching TBT like securities for a while, but always been afraid of touching them due to Fed's stated goal of holding treasuries to manage rates.

"In addition to maintaining an exceptionally low level for the federal funds rate, the Committee expanded the Federal Reserve's holdings of longer-term securities as a means to put downward pressure on longer-term interest rates and make broader financial conditions more accommodative. These actions have helped to support a stronger economic recovery and ensure that inflation, over time, is at levels consistent with the Committee's mandate to maintain maximum employment and stable prices"

The question is - what prevents them from buying treasuries in secondary market as well, in the name of their "broader mandate"

Tom said...

Nothing at all. I expect they will. But what will they buy them with? They buy long term debt with short term debt or Fed Funds (basically overnight lending). The result is cash in the market instead of debt, which in a closed system would produce a falling dollar, but which overseas markets prop up because it's safer to hold US assets, and because they want the inflation themselves. Until of course they don't.

We like to think of the markets as a thermometer. they haven't been for a while, and the linked piece explains why. As the hedge fund space dries up, they'll become one again. Ironically, this will make it possible again, for Hedge Funds to turn a profit.

Go figure.

Tom said...

Basically what I'm saying is that interest rates and currency strength won't be good indicators of inflation. Hedge Fund redemption will be a better indicator since it will be a reflection of the reduction in overall leverage.