Over explaining the London Whale
Producing a colorable response to the question of what precisely JPMorgan’s Chief Investment Office and Bruno Iksil were doing writing $100 billion in credit protection is not a simple task. Case in point, John Carney’s explanation:
Traders I spoke with say that Iskil is probably using the CDX trade as part of a strategy to hedge inflation rate risk. The clearest way to hedge inflation risk is to buy Treasury Inflation Protected Securities, or TIPS. But the yield on 10-year TIPS has been so low it has sometimes fallen into negative territory.
JPMorgan may be seeking to combine the inflation protection of TIPS without locking in the low yields by pairing its TIPS purchases with selling protection on CDX. The idea is to skim the higher yield offered in corporate bonds to balance out the low yield of the TIPS. This could even be somewhat self-financing, as the income from selling protection could be used to purchase the TIPS.
This is interesting, but interesting in a polite, refusal to offer a strong verb of rejection way. It is true that the operations and decisions of global financial institutions regularly defy simple explanation. That said, the theory that this trade is really all about inflation and the low yields offered by TIPS is far fetched. Sure, the CDS could be a funding mechanism to buy TIPS. But so could any number of other transactions in far more liquid markets than Iksil’s chosen off-the-run CDS. Fundamentally, CDS is about credit-worthiness and it would be odd for a lender to further increase their credit exposure as means to partially fund an inflation hedge.
Carney is absolutely right that JPMorgan has done very little to help explain what it is really doing here. But in an attempt to find a workable explanation for how Iksil’s behavior could in fact be a hedge, Carney has replaced Dimon’s obfuscations with a non sequitur of his own. If Iksil wanted to hedge inflation, buying TIPS is all he needs to do. And if he wanted to fund that purchase, why would he choose selling protection on an off-the-run CDS index as a way to do that?