About a year ago, Goldman Sachs experienced an unprecedented P&L wipe out after in Q2 it bet on a decline in volatility, only to be caught offguard by the first Greek bailout which in turn cost the firm's prop desk hundreds of millions in losses. Now, about a year later, it is again the same sellside hubris and pretty much the same players that make a repeat appearance, after Bloomberg just disclosed that a very wrong way bet on 5 and 30 year TIPS breakevens has cost the interest-rates trading group "at least tens of millions of dollars." And while Jim Caron's traditionally wrong rates call has up to now only cost his clients money, this time it is his own trading desk that may be left collecting the shrapnel. But topping off the irony is that it is once again an ex-Goldmanite who is responsible for the actual trade. Per Bloomberg, "The interest-rate group is run by Glenn Hadden, who Morgan Stanley hired from New York-based Goldman Sachs in January." News of the loss made their way through the trading community earlier and was manifested in the weakness of the "hedge fund" banks: the Goldmans, the JPMs and, of course, the Morgan Stanleys of the world. As a result, MS is now forced to unwind the trade at a major loss (at least for the current quarter, we have to ask John Paulson if the trade is profitable on a cost basis), which will likely have substantial repercussions for the short and long breakeven curve for days, if not weeks.
What exactly did Morgan Stanley do wrong? Well, nothing much, until recently, at which point... everything. The firm had bet that the spread between the 5 year and 30 year inflation breakeven (matched maturity TIPS less Treasury) would tighten in hopes that near term (5 year) inflationary expectations would rise as 30 year inflation would drop. In other words, in the chart below, MS was hoping the line would keep dropping ever lower. Whether this is based only on technicals (it certainly seemed to be working for a while), or on fundamentals (enter Jim Caron) is not clear. And irrelevant. The chart below shows just what happened over the past 6 months. The trade worked, worked, worked, Hadden had already spent the bonus money in his head on that 4th Southampton cottage, when suddenly... poof. Everything imploded, following last week's insane market action courtesy of the IEA.
As Bloomberg explains: "Declining crude oil prices disproportionately hurt the value of TIPS maturing within five years because they have fewer remaining interest payments that can benefit from a rebound in prices. The five-year breakeven rate dropped to 1.88 percent yesterday from 2.04 percent at the end of May, indicating underperformance by five-year TIPS relative to nominals."
This unprecedented divergence can be seen on the standalone breakeven chart below (we have added the 29 Year Breakeven TIPS for a better correlation comparison):
And the blow by blow from Bloomberg:
The 30-year breakeven rate climbed to 2.57 percent yesterday from 2.42 percent at the end of May, indicating outperformance by the 30-year TIPS relative to nominals. The June 23 auction was awarded to investors at a lower-than- expected yield last week, a sign demand outpaced dealers’ expectations. The TIPS drew a yield of 1.744 percent, 4.8 basis points lower than where they were trading at the auction deadline.
Well, there goes another quarter of Morgan Stanley interest rates profits. And judging by how horrendous Caron's other calls have been in 2009, 2010 and 2011, we would be shocked if this is the only latent time bomb at Morgan Stanley.
What is ironic is that everyone and their grandmother will now slowly bleed MS' team to death as it is forced to unwind the spread, only to immediately put the compression trade back on, at which point the 30Y - 5Y will resume its tightening bias.... Until some other trading desk blows up on the next black swan event.
And it was only yesterday that James Montier was saying that Black Swan insurance is overrated...