Cool inflation, dizzying markets | Financial Times

Good morning The markets loved Thursday's inflation report, and so did we. But we believe the inflation battle is far from over. The fight for FTX will also take a while. Our thoughts on both below. Send us an email: robert.armstrong@ft.com & ethan.wu@ft.com.

Inflation, cooler, but mostly the same

It's not without reason that the stock market rises 6 percent in one day. Yesterday delivered one: significantly cooler inflation numbers, which raised hopes that the US Federal Reserve could retreat and finally form a market bottom.

The CPI report is, in fact, confirmation that the disinflationary trends visible in everything from housing declines to job losses are real. As a result, markets have lost a lot of upside inflation risk. Futures traders' implicit expectations of where interest rates will be at the end of 2023 fell sharply, while expectations for the next few months fell only slightly. The market believes longer-term higher interest rates are less likely today than they were on Monday.

What did the CPI numbers actually say? Last month, based on conversations with inflation specialists, we made four predictions for the just-released October inflation data (remember, the top inflation categories for services, from most important to least important, are housing, medical care and transportation):

1. Core goods (e.g. food and energy) would begin to deflate.

2. Transportation services would remain volatile but would gradually ease as airfares calm down.

3. An annual update of the health insurance data used to price medical services would lead to a brake on inflation.

4. Shelter would stay pretty hot.

Yesterday's inflation numbers delivered on all four counts. The following graphic summarizes. The top four rows are for October, the bottom four for September:

Prices for core goods and medical services are falling, while transport prices are rising somewhat more slowly.

Shelter was a little trickier this month. The most important point is that it has been slowed down slightly, but there is a complication. As you can see in the chart above, the accommodation category accelerated in October. But under the hood, the two most influential subcategories - rent (from 0.8 percent to 0.7 percent) and owner equivalent rent (0.8 percent to 0.6 percent) - fell. This was due to the explosive acceleration in a little-noticed subcategory: hotels (up 5.6 percent in one month!).

But that looks like noise. As Inflation Insights' Omair Sharif explained to us, the hotel component doesn't tell us much about accommodation:

What's really included in CPI are hotels near vacation destinations, ski resorts, beaches, and the like. Not the hotel down the street from your parents' house. If there are fluctuations in resort prices, it will show in the hotels.

And since the overall hotel index is right on trend before the coronavirus pandemic, we're not too worried.

Looking back, yesterday's report didn't change the picture significantly. Inflation has peaked; it comes down; How quickly it comes down depends on the shelter. And the prices for accommodation are likely to slowly fall. As we noted, there is a catch-up effect in rent levels that could lift inflation for a few months.

We're glad that inflation isn't running wild, but the central hypothesis remains the same: Inflation causes the Fed to keep interest rates restrictively high for a while, leading to a recession. What happens at the margin - inflation falling a little faster, interest rates rising more slowly - still matters. But the bigger picture – hot inflation, penalty interest rates – is more important. (Ethan Wu)

FTX again

From a Reuters story published yesterday about FTX and its CEO Sam Bankman-Fried:

This May and June, Bankman-Fried's trading firm, Alameda Research, suffered a series of trading losses, according to three people familiar with its dealings. . . To prop up Alameda, which held nearly $15 billion in assets, Bankman-Fried transferred at least $4 billion in FTX funds secured by assets such as FTT and shares in trading platform Robinhood Markets Inc., the people said. . . Some of those FTX funds were customer deposits, two of the people said

Here's the Wall Street Journal, also yesterday, on the same topic:

Crypto exchange FTX lent billions of dollars worth of customer assets to fund risky bets by its affiliated trading firm Alameda Research. . . Chief Executive Sam Bankman-Fried said at investor meetings this week that Alameda owes FTX about $10 billion, people familiar with the matter said. FTX made loans to Alameda using funds that customers deposited on the exchange for trading purposes. . . All told, FTX had $16 billion in customer assets, the people said, so FTX lent more than half of its customer funds to its sister company Alameda.

I don't know if it is legal for a person to transfer customer funds from their crypto exchange to their hedge fund because I don't know what a crypto exchange is under the laws of the Bahamas, the Cayman Islands, the Forest Moon of Endor, or wherever the companies involved are based.

However, there is no doubt that such a transfer is extremely risky. It takes assets from an institution that has on-demand liabilities and replaces them with an IOU. This increases the risk of a bank run. Additionally, as the Reuters story states, the notes were largely collateralized by FTT, a token the lender invented. This is crazy in many ways, I don't have space to put them here. Finally and obviously, such a transfer implies an icy disregard for the exchange's customers.

Bad things. But it helps explain what it's about. FTX cannot fulfill customer withdrawals because it has given customer assets to Alameda and cannot get them back, at least not in a liquid enough form to be useful.

But this simple story is confounded by another Account published yesterday. It came from Bankman-Fried himself via Twitter. It contained two material claims. The first:

FTX International currently has a total asset/collateral market value greater than customer deposits (moves with prices!). But this is different than liquidity for delivery – as you can see from the status of withdrawals.

In other words, FTX is solvent (in the limited sense that it has enough assets to eventually make good on its customers) but not liquid (in the sense that it has enough easy-to-sell assets to make good on customers soon). It just takes enough time to sell some assets that are difficult to sell. And what error led to this liquidity problem? No major transfer of assets to a hedge fund. Instead, FTX’s customers were much more leveraged than Bankman-Fried knew. This is the second material claim:

. . . Poor internal labeling of bank-related accounts meant my sense of user profit margin was significantly off. I thought it would be much lower.

The users' leverage was 1.7, not 0 as he had thought, Bankman-Fried said (this must be on some sort of net basis, as obviously many FTX customers had leverage, leverage is something FTX sells). So for every dollar of customer deposits, customers borrowed a total of $1.70 from FTX. And the result was that there was no longer enough liquidity to handle the rush of withdrawals at the end of last week.

But why should customers with leverage – in short, FTX funds – create a liquidity problem in the face of mass withdrawals? The only way I can think of is if the loans are provided by the exchangetoCustomers were financed through loansout ofsomeone else, and that someone else wanted their money back at the same time customers did.

That could happen, but if it did, Bankman-Fried's mistake looks much more stupid. He suggests he owed billions of dollars in callable loans to a third party, and he didn't even know roughly how much.

We still have more questions than answers. Namely:

• Can both the news reports and Bankman-Fried's Twitter thread be true?Yes, in a narrower sense. It could be that FTX is solvent and illiquid,andthat the client's leverage made meeting withdrawals more difficult than it would otherwise have been,andthat FTX Alameda has lent billions of dollars in customer assets. It's just that FTX is much less solvent and liquid than it would have been if this loan hadn't existed. Of course, if Bankman-Fried wrote this long thread about being more transparent and how sorry he is and just decided not to mention that he also lent his hedge fund billions of dollars in client assets against the worst collateral imaginable, then he is an idiot of world-historic proportions. But that is another topic.

• Isn't it strange that FTX says it is solvent (in the limited sense described above) but needs a hefty sum8 billion dollarsof liquidity?You bet your ass it's weird (and FTX could be bankrupt or almost bankrupt, according to Bloomberg).

• If FTX is solvent, why can't it find someone to lend it the liquidity it needs?? Maybe it can, and it will just take some time. Perhaps the problem is that, while lending the money to FTX would be a smart financial move, no one with $8 billion would. Additionally, lenders may not believe FTX's books are accurate, given its history of, um, poor internal labeling of bank accounts.

• Can Bankman-Fried's assumption that unexpectedly high customer debt led to the liquidity crisis stand up to scrutiny?? Yes, but there is a much simpler explanation: that FTX did not have enough liquidity because it made a stupid and grossly immoral loan to Alameda.

There is a lot we don't know yet.

A good read

Murdoch versus Trump.