ArticlesMarket CommentaryYes Free Lunch?

Yes Free Lunch?

Hand grabbing a slice of pizza. Photo by Polina Tankilevitch:


  1. March CPI and PPI came in lower than expected
  2. Gold and Ethereum both rise above $2k level
  3. Swap spreads show signs of banking stress

We were decidedly bullish last week. Labor data was weak, and the softness has been reaffirmed this week by softer headline CPI and PPI this week. Markets woke up post-PPI and rallied strongly, sending both gold and ETH above local highs.

Sometimes it pays to keep it simple, and this is such a week. Nothing in the story has changed, but there are rumblings in the geopolitical space, apparently serious enough for Buffett to dump most of his stake in TSMC within a few months of buying.This technically happened by the end of 2022, but it is now reported that his motivation was mainly due to geopolitical uncertainty around the situation in Taiwan.

Despite recent naval exercises by China in close proximity to Taiwan, markets seem to shrug off such concerns as mostly saber rattling despite increasingly aggressive rhetoric. In an apparent tit for tat reaction, The situation is set to escalate further as the US begins its largest ever military drills in the Philippines. Naturally, this adds pressure to those concerned about disaster hedging and is certainly supportive of the yellow metal. Which brings us back to…

March CPI and PPI Lower Than Expected

Core CPI was largely inline at 0.4% MoM whereas the headline numbers dropped to 5% (5.1% expected). Markets were not convinced however, and Wednesday’s rally was short lived. Thursday’s PPI numbers changed the mood and you could literally hear the starting pistol being fired. 

Source: Wall Street Journal/Labor Department

From a macro perspective, the key thing to note is that core and headline numbers do not cross often, but when they do, they tend to stay that way for a while. This means that regardless of the headline numbers next month, it’s likely that the core number will be slightly higher, dampening any market moves that may happen from drops in inflation.

This did not change market expectations for the Fed to start tapering. There’s more than ⅔ chance we hike by another 25 bps despite calls from many market participants that say that rates are too high.

Source: CME FedWatch

Those betting against the Fed can find comfort in precious metals and crypto markets.

Gold and Ethereum Rise Above $2k Level

The weakness in inflation has emboldened gold bugs and others who believe the Fed will resort to quantitative easing to combat the looming credit crunch induced by the banking crisis. There’s definitely a relationship between gold post-1971 when the US dropped out of the dollar gold peg and the M2 money supply.

Source: TradingView

You can’t really see it in this chart but M2 has decreased slightly since the peak in 2021. If you believe this ultra long term model, then there is a good case that regardless of what the Fed does, the downside for gold is limited unless they are able to drastically reduce M2, which is essentially impossible to do. And keep in mind, there are more economies than just the US. I haven’t checked what this chart looks like if you add Europe + BRICS, but it can only make gold look better.

As for Ethereum, it is a different story. The eagerly anticipated Shapella upgrade occurred on April 12th, allowing validators of the blockchain to finally withdraw their stakes. Some believe this will put near term pressure as those that withdraw their stakes are likely to sell, whereas others believe it will help Ethereum as it will encourage more institutional investors to buy in now that there is a clear path to liquidity.

Based on the price action, it seems that a successful chain upgrade is mainly a de-risking event, and caused ETH to break above the critical $2k level. 

Meanwhile, in the traditional economy, while regulators continue to assure us everything is alright, the biggest derivatives market in the world is sounding the alarm.

Swap Spreads Show Signs of Banking Stress

The interest rate swaps market is the largest over-the-counter (OTC) derivatives market in the world. It’s so big you can’t imagine how big it is. It’s as if you walked into a room and got startled by the gorilla, and failed to notice the Empire State Building it is standing on.

According to the Fed, the swaps market has hundreds of trillions (yes with a T) of notional exposure. So whenever something happens there, people should take heed.

This week, the swaps market is flashing red. A key measure of liquidity and funding for banks is the yield differential between treasury yields and the rate on corresponding interest swaps.

Source: Twitter/Jeff Snider

The above shows this spread for treasury bonds of different maturities (5y, 10y, and 30y).

This market is used by large financial institutions to hedge against interest rate risk, and this spread is a measure of the cost of hedging treasuries (remember the thing that exploded SVB’s balance sheet?).

So when this number is positive, it means you pay a little extra on the swaps that you would receive on your treasuries, chalk that up to the cost of doing business! But when this spread is negative, it means you get PAID to hedge out that risk.

Now, since you hold treasuries and there’s no credit risk, and you’ve just now removed interest rate risk, you are essentially able to generate free money!

But, isn’t there no free lunch in economics? So what’s happening here? Well in this market, the only people able to help you get into this trade are banks since they are the only interest rate swap intermediaries. Also, because one leg of the trade involves buying treasuries, they have to hold those treasuries in their books, or borrow it from someone else, on your behalf.

Banks charge fees for using their balance sheets because they need to have enough money set aside in case they lose money on a trade. When swap spreads become negative, it means that banks and/or their clients are not interested in making easy money by taking advantage of the situation. This is a sign that there may be problems with getting funding in the banking system.

Ivan’s Take

Having traded interest rate swaps for over a decade and seen this dynamic play out multiple times, it is pretty apparent that the regulators will have to pivot soon despite their assurance to the contrary. 

These spreads are usually very stable, and because of this, massive amounts of money flow between the swaps and treasury markets. When these spreads become unhinged, you are no longer able to hedge one with the other, causing massive potential losses. Alternatively, the volatility can reduce the liquidity of these markets, which can lead to an increase in funding pressures, not a good dynamic in a centi-trillion dollar market.

So while I was wrong in hoping that the Fed would pause in March, (it wasn’t a high probability they would pause at that time), a 70% likelihood for yet another hike next meeting is just too high. Bank stocks have not rebound since SVB’s collapse. Yes, JPM has hit the ball out of the park, but…it looks more like taking a greater piece of a shrinking pie rather than a tide that’s lifting all boats.

Source: KBW Bank Index/CNBC

That’s all for now, see you next week!

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