http://www.bloomberg.com/news/2011-...rading-loss-after-wager-on-u-s-inflation.html "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!
Dumb it down... They were short longer duration treasuries (think 30yr) , and long inflation assets like OIL... they probably thought they had a kind of spread trade on and the expected correlation if they had one, blew out.
No, that's completely incorrect... The trade was a 5s30s TIPS breakeven flattener. So it's a trade that consists of four bond positions: long 5y TIPS, short 5y nominal Treasuries, short 30y TIPS, long 30y nominal Treasuries. In general, the position has a positive beta to inflation (i.e. it works in a rising inflation environment). However, they got into it at utterly wrong levels, which made it a really stupid trade (and motivation was not just inflation, but rather supply).
They had multiple long end bets that went wrong. The story I've heard was that it was two separate trades, one was a large spread of swap spread trade (10s30s SoS from my coverage) and another one was the 5s30s TIPS steepener (in real yields).
Do you guys think these trades make sense at all? How can one reliably forecast inflation into 30yr period?
Well, nobody is really trying to forecast inflation for the 30 year period, in all of these trades you are just trying to forecast the changes in long-term expectations of inflation. For starters, it's worth reading http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_faq.htm to understand the basics about TIPS.