http://www.bloomberg.com/news/2011-06-2 ... ml"Traders at the bank bet that inflation expectations for the next five years would rise in Treasury markets, while forecasts for the next 30 years would fall, according to two of the people. Such wagers on so-called breakeven rates involve paired purchases and short sales of Treasuries and Treasury Inflation Protected Securities, or TIPS, in both maturities. "Anybody please dissect the trade for me a bit? And why did it go awry?Thanks!

Hi Mizhael,So this trade is a combination of two different concepts - a curve trade and a breakeven trade with TIPS. For the breakeven part, we buy/sell TIPS and sell/buy Treasuries - the difference in yield is the amount of inflation needed to break even on the trade (hence the term breakeven). For example, if we think inflation will go higher, we would buy TIPS and sell Treasuries since TIPS would hold their value better under a rising inflation scenario. This would be a breakeven widener. The opposite would be a breakeven narrower where we would expect inflation to go down. For any given maturity, the breakeven represents the market's expectations for inflation over that period - so a 5y breakeven trade (i.e. buy/sell 5Y TIPS and sell/buy 5Y Treasury) approximately represents the market's expectation for inflation over the next 5 years. For example, currently the 5y breakeven is roughly 1.9%, i.e. that is the expected level of headline inflation expected over the next 5 years. Similar logic on the 30 year. So the MS trade took a view that 5-year breakeven rates would rise and 30-year breakeven rates would fall, thus narrowing their difference. Such a trade would be called a breakeven curve trade and would use 4 legs to execute (buy 5y TIPS/sell 5y Tsy and sell 30Y TIPS/buy 30Y Tsy). So the reasoning behind this trade - well essentially its taking a view on shorter term inflation drivers versus longer term inflation drivers. Different fundamental and technical factors drive inflation expectations for 5y period and 30y period - the curve trade, by buying the 5y breakeven and selling the 30y breakeven is taking a view on the differences between these drivers. The trade is less concerned about the overall lvl of inflation though changes in that are likely to affect the 5y and 30y differently.For TIPS, one key thing to remember is that it is based on headline inflation, which includes food + energy CPI, not just core. These effects are especially strong for the shorter term inflation periods - for 1-5Y TIPS, oil prices can be a big driver as oil prices are big drivers of headline CPI. Thats why the article mentions falling oil prices messing up the trade. If oil drops, inflation expectations, i.e. breakevens narrow much more at the front end, which was opposite the position put on. For the 30y breakeven position, oil is less of an issue since it is a long term inflation view. Instead, 30y breakevens are driven by both expectations of quantitative easing and technical factors around auctions since its a much less liquid sector with fewer players. The quantitative easing matters for 30y breakevens because the Fed does not interfere much with 30y bonds in its qe program and as QE is initiated/finished, the long term inflation worries of the market will get reflected in the 30y sector. For this curve trade though, declining oil prices were the main factor I think. The sharp drop in oil prices from 110+ to 90 in WTI crude oil, as well as weakening economic data dropped the 5y breakeven by over 60bps since mid april. For 30y these shorter term factors matter less, and it has only declined around 20bps since mid april. In essence, this trade ended up being a view on oil prices and economic data and for all its complexity, one could have just traded oil at probably lower cost....hope this helps..btw, for more on rates/breakevens including both setting up common trades and the reasoning behind many trades institutional clients do, check out:

It's a trade that was supposed to work on the back of inflation rising and also supply... The oil mkt didn't cooperate and rest is history.

QuoteOriginally posted by: secondmomentHi Mizhael,So this trade is a combination of two different concepts - a curve trade and a breakeven trade with TIPS. For the breakeven part, we buy/sell TIPS and sell/buy Treasuries - the difference in yield is the amount of inflation needed to break even on the trade (hence the term breakeven). For example, if we think inflation will go higher, we would buy TIPS and sell Treasuries since TIPS would hold their value better under a rising inflation scenario. This would be a breakeven widener. The opposite would be a breakeven narrower where we would expect inflation to go down. For any given maturity, the breakeven represents the market's expectations for inflation over that period - so a 5y breakeven trade (i.e. buy/sell 5Y TIPS and sell/buy 5Y Treasury) approximately represents the market's expectation for inflation over the next 5 years. For example, currently the 5y breakeven is roughly 1.9%, i.e. that is the expected level of headline inflation expected over the next 5 years. Similar logic on the 30 year. So the MS trade took a view that 5-year breakeven rates would rise and 30-year breakeven rates would fall, thus narrowing their difference. Such a trade would be called a breakeven curve trade and would use 4 legs to execute (buy 5y TIPS/sell 5y Tsy and sell 30Y TIPS/buy 30Y Tsy). So the reasoning behind this trade - well essentially its taking a view on shorter term inflation drivers versus longer term inflation drivers. Different fundamental and technical factors drive inflation expectations for 5y period and 30y period - the curve trade, by buying the 5y breakeven and selling the 30y breakeven is taking a view on the differences between these drivers. The trade is less concerned about the overall lvl of inflation though changes in that are likely to affect the 5y and 30y differently.For TIPS, one key thing to remember is that it is based on headline inflation, which includes food + energy CPI, not just core. These effects are especially strong for the shorter term inflation periods - for 1-5Y TIPS, oil prices can be a big driver as oil prices are big drivers of headline CPI. Thats why the article mentions falling oil prices messing up the trade. If oil drops, inflation expectations, i.e. breakevens narrow much more at the front end, which was opposite the position put on. For the 30y breakeven position, oil is less of an issue since it is a long term inflation view. Instead, 30y breakevens are driven by both expectations of quantitative easing and technical factors around auctions since its a much less liquid sector with fewer players. The quantitative easing matters for 30y breakevens because the Fed does not interfere much with 30y bonds in its qe program and as QE is initiated/finished, the long term inflation worries of the market will get reflected in the 30y sector. For this curve trade though, declining oil prices were the main factor I think. The sharp drop in oil prices from 110+ to 90 in WTI crude oil, as well as weakening economic data dropped the 5y breakeven by over 60bps since mid april. For 30y these shorter term factors matter less, and it has only declined around 20bps since mid april. In essence, this trade ended up being a view on oil prices and economic data and for all its complexity, one could have just traded oil at probably lower cost....hope this helps..btw, for more on rates/breakevens including both setting up common trades and the reasoning behind many trades institutional clients do, check out: a lot for your explanation. I am going to take a look at the book.What are the Bloomberg tickers for the 5yr and 30yr bonds you've mentioned above? I am trying to playback the loss...

QuoteOriginally posted by: MartinghoulIt's a trade that was supposed to work on the back of inflation rising and also supply... The oil mkt didn't cooperate and rest is history.Do you think this trade makes sense? I mean, who can forecast the inflation over 30 years?

Well, it's not really about forecasting inflation. It's about a view on how much inflation risk premium should be priced into the TIPS breakeven curve, given a whole variety of macro factors, as well as other considerations (i.e. the fact that the Treasury keeps supplying 30y TIPS).