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Good morning Markets took one look at the consumer price index yesterday and went right back to bed. The Vix and Move volatility indices are back near their recent lows. Yawning. Wake us up with an invigorating email: [email protected] and [email protected].

CPI: Just bad enough

The August CPI report wasn’t terrible. With core inflation at 0.3 percent, it was somewhat positive. But the key trends – rent and goods inflation – remained.

But there was a hint of inflation risks that still exist. Start with core non-housing services, the Fed’s inflation bugbear. After four months of encouraging slowdown, August saw a 0.4 percent increase (dark blue line below):

The main culprit was transport services, particularly the capricious airfare category. Transportation services, which account for 7 percent of core CPI, rose as much as 2 percentage points in August, driven by a 5 percent increase in airfares. OPEC is to blame. Production cuts have helped push oil prices to over $90 a barrel from below $70 in June. Airfares are highly sensitive to fuel costs, and transportation is more energy dependent.

The rise in oil prices, which has lost momentum, could ease. However, a persistently high oil price poses inflation risk through two channels. One of them is inflation expectations. The overall inflation that people are experiencing rose 0.6 percent in August. Gasoline prices are everywhere and play an outsized role in people’s perceptions of price levels. It should be noted that long-term inflation expectations are already at the upper end of their historical range.

The second possibility is the direct impact on core inflation. Over a three-month horizon, a 10 percent supply-driven oil price shock increases core inflation by only 3 to 5 basis points, Morgan Stanley economists estimated in a note yesterday. But a prolonged price increase “could impact core inflation as price contracts reset and companies have pricing power to pass on higher prices to consumers,” they write.

Another risk is the breadth of inflation. It’s not just about transport or energy. Omair Sharif of Inflation Insights notes that several unexpected categories gained, including home furniture and medical supplies. Underlying inflation metrics also rose following yesterday’s data:

There’s a broader idea here: in addition to everything that can be learned from slicing and dicing the data, a top-down approach also needs to be considered. This cycle has been inscrutable, but the fact is that spending is currently high. Until proven otherwise, we must assume that economic resilience matters for inflation and that high corporate profits and wage growth are not accompanied by a tidy return to 2 percent. We’re still holding our breath about inflation. (Ethan Wu)

The big bad base trade

Since the Great Financial Crisis, people have tended to become concerned when large amounts of leverage build up in a financial market, as was the case in the housing finance market prior to 2008. Everyone knows this mess won’t happen again, but they’re sniffing around looking for an analogous mess so they can avoid it, profit from it, or (in the case of people like me) look smart by noticing the problem before it explodes, and then write a book about it.

Lately, people have been looking at treasury basis trading with trepidation (or is it anticipation?). The Treasury market is a good target for fear. It almost failed in 2020 when volatility increased, liquidity disappeared and the Fed had to intervene. This could have been caused by speculators who had leveraged their exposure to government bonds, which they had to abandon in a hurry.

Basis trading is a form of this speculation. It works like this. I sell a number of futures contracts. That is, I agree to buy a lot of Treasury bonds at some point in the future at a certain price, for simplicity’s sake let’s call it $100.50. Let’s call it three months. Now I buy a bunch of Treasuries for $100 (why are the futures more expensive than the cash Treasuries? Mainly because there is a lot of demand for futures to hedge interest rates). At the end of the three months, I complete the futures trade and put up my $100 Treasury bond in exchange for $100.50. I earned 50 cents. Yay. The beauty of this trade is that it is coordinated. For the most part, I don’t care what happens to the price of Treasuries or Treasury futures over the life of the trade. All I have to do is hold the treasury and then deliver it as specified in the contract.

The problem is that 50 cents is not an attractive return on a trade that locks up $100 for three months. It’s not as good as simply buying a Treasury bill. But because the trade is balanced – it’s almost pure arbitrage – I can borrow tons of money to set it up. This is even more so since it is based on Treasuries, the risk-free asset. Roughly speaking, I can borrow $98 to buy that $100 in Treasury bonds, using the Treasury bonds as collateral. At 50x leverage, the returns start to look good, even after deducting the cost of all the leverage.

But leverage makes trading risky, as an excellent 2020 report from the Office of Financial Research explains. The first problem is that the deals are typically funded through the overnight repo market. If interest rates change and this financing becomes more expensive, it could wipe out the profits from the deal and more, forcing me to rush the deal. Additionally, if Treasury or Treasury futures prices change, I will be required to deposit additional margin with my lender or futures clearinghouse. As long as they move in the same direction, I’m mostly fine, because if one needs more wiggle room, the other needs less. However, when they move in different directions, I have to get out as quickly as possible.

If one of the risks takes effect, I will sell my government bonds in a hurry. If many traders do this at the same time, sales could overwhelm buyers, causing panic in the world’s most important securities market and the disappearance of liquidity – a situation similar to that of March 2020.

The reason is that everyone (the Fed, the Financial Times, the Wall Street Journal) is focused on basis trading right now because the market is suddenly seeing a lot of Treasury futures selling, more evenly than in the lead up to the car crash of 2020. A chart the exposure by Ian Harnett and David Bowers from Absolute Strategy Research:

One reaction to leverage in the Treasury market is to wonder why the hell the speculators didn’t learn their lesson the first time. But of course they learned their lesson: The lesson is that if things get really bad in the Treasury market, the Fed will step in. The only surprising thing about the return to high debt levels is that it took up to four years.

This gets to the heart of the problem: When leveraged speculators cause a problem in the Treasury market, innocent bystanders get hurt. People like banks and insurance companies, for example, rely on the treasury market to manage liquidity, and every price signal in the world goes haywire when yields rise. The best possible outcome – that the speculators and their investors are crushed and prudence returns to the market – has unacceptable side effects. Regulation, including capital requirements for Treasury market participants, is becoming increasingly attractive to people like the SEC’s Gary Gensler.

However, the problem with regulating leverage in one place is that it tends to pop in another. There really is no discipline like market discipline. Part of the solution must be accepting that perfect liquidity in the treasury market is a fantasy and that everyone from banks to hedge funds will have to scale down their business models accordingly. The alternative is to jump from one crisis to the next.

A good read

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