Re-thinking the short long-bond trade
Like many followers of this site, I am short long-dated U.S. treasury bonds. In fact that trade represents the largest single position in my investment portfolio. The logic should be familiar to CM.com readers: Lending money to an insolvent borrower on an unsecured basis for 30 years at four percent interest is nothing short of insane. Therefore, foreign lenders should be expected to eventually wake up and stop throwing good money after bad. When they do the U.S. will be forced to allow interest rates to rise dramatically in order to attract risk capital to fund the country’s budget deficit, and thus treasury bond prices will collapse.
But all of that is based to a large extent on “rational expections theory”, i.e. that the government will behave rationally when confronted with the threat of China and other foreign lenders cutting off their credit. I always like to think about why I might be wrong in my investment strategies, so I started to ponder scenarios where the foreigners stop lending but treasuries don’t collapse in price as a result. I surprised myself when I realized that there really are entirely plausible scenarios where the foreigners stop lending but treasuries don’t collapse as a result. Then I surprised myself even more with the realization that some of those scenarios could already be occurring.
Here’s my fear: Suppose that China says “Ok, enough is enough. No more good money after bad. We’re going to stop buying U.S. treasuries and just allow our currency to appreciate rather than continue this insanity!”. So they stop buying and there is a shortfall of bids needed to keep interest rates at target levels in the treasury auctions used to finance the US Gov’t’s massive borrowing needs. Put in the position of the U.S. gov’t, any rational actor would recognize that the only available course of action is to dramatically cut spending, reduce borrowing, and contain interest rates. But we’re not talking about rational actors. We’re talking about politicians.
So what if they responded by simply monetizing as much debt as necessary to make up the shortfall in foreign investment? Set a target yield for each auction ahead of time, and instruct the Fed to engineer that outcome by printing as much money as necessary for the Fed to buy the excess supply, to assure the yield target is always hit. If this were already happening, it would perfectly explain why the Fed has so strongly resisted an audit of its books.
I know what you’re thinking… That would never work because the result would be that the dollar would collapse after foreigners figured out the game and realized that investing in the U.S. is going to be a sucker bet for the forseeable future. But that only happens when everyone figures out the game. If you can hide what’s happening for long enough, you can either fake out the market and get away with it, or (in the eyes of a politician) delay the really big crash until the next guy’s watch.
If the Fed were to monetize indefinitely, treasury prices would never collapse. That is a simple matter of auction mechanics. The expected result of such a policy would be a dollar collapse, but in nominal terms, treasury prices would never decline even if their value were crashing in real terms. Short sellers don’t get paid when prices fall in real terms; only in nominal terms. The DX would eventually crash, but only after the gig was up and foreigners figured out the scam.
So next I thought, “Ok, so a short long bond trade doesn’t make sense in isolation, but short long bonds and short the DX at the same time should cover both bases.” Sadly even that doesn’t work. The only way to short the DX is through dollar-denominated futures contracts. So what would happen is the short long bond trade never pays off because thanks to reckless monetization, the nominal prices are managed to keep interest rates at target levels. When the scam is exposed the DX crashes suddenly and dramatically, going to near-zero levels. Short sellers of the DX then reap a huge “profit” in now-worthless U.S. dollars!
But that’s not the only scenario where I could see the short long-bond trade going wrong. Perhaps a more realistic one is that the politicians reframe what is going on, intentionally misleading the American Public to blame the wrong parties and to subsidize the government’s reckless spending. Let’s expore that one…
China and other foreign lenders wise up and decide to stop throwing good money after bad, causing strong upward pressure on long-term interest rates, and therefore on mortgage rates. That’s hitting the American homeowner where it hurts most, and that perfectly sets the stage for the politicians to distort the truth. I can hear Obama’s speech in my head already…
We are a great nation of kind and generous people. We have therefore shared our prosperity with the rest of the world, and at the regrettable cost of millions of American Jobs, our nation has almost single-handedly financed the growth of China from a nation of rice patties to a rapidly developing industrial complex. But to our shock and horror, the Chinese government has now turned on us. In an act of what might even be termed financial terrorism, they have sabotaged our treasury auction process by suddenly and unexpectedly taking steps that they knew full well would cause our mortgage interest rates to skyrocket. This selfish action by China, a nation who owes its own prosperity to the generosity of the United States, is unthinkable but it’s happening.
So now, my fellow Americans, I must appeal to your patriotism. It’s time to say “no more” to shipping our manufacturing jobs overseas. And its time to invest our own savings in the greatest nation on earth: The United States. So I am calling on all Americans to do your patriotic duty and help your nation avoid calamity by investing your own savings in the safest investment on earth: U.S. Treasury Bonds. And to assure that this duty of patriotism is met, I am asking the congress to impose a 90% tax on all Americans earning more than $250k/yr or who have more than $2mm in financial assets. The exploitation of this great nation by own own trading partners must not be allowed to continue, and the time for action is now.
Can you imagine Hilary Clinton’s rhetoric?
Sadly I saw this coming back in 2009, and because I am committed to keeping hard-working Americans in their homes, I personally traveled to China to obtain assurances that this would never happen. But sadly the Chinese have double-crossed us…”
Talk about killing several birds with one stone. This would allow the government to distract attention from its own failures by giving the people someone to blame (the Chinese), creating the public support for another Military conflict if the gov’t so desires, and giving them reason to believe that their problems were not created by their own goverment but by a foreign one. Nancy Pelosi would have a field day. It would be pretty easy to persuade the sheeple that it’s their patriotic duty to put all their retirement savings into U.S. treasuries. And that would fund the charade for another act or two. Anyone trying to interject reality or common sense would be denounced as unpatriotic, and the people would come together to stand behind the good ‘ol Red White and Blue to do the right thing: Invade China and steal that nation’s wealth and natural resources in “retaliation” for the evil they would be alleged to have tried to perpetrate against the U.S.
Alternatively, you could just send Hilary over to outline this exact scenario to the Chinese, remind them of our nuclear supremacy, and then politely suggest to them that they probably ought to keep on buying those treasuries, even if they decide it’s not a good investment. Perhaps that was the real pupose of her trip to China last year?
Anyway, my point is simply that a lot of us having been hanging our hats on the “sure bet” that eventually, interest rates have to rise, probably very rapidly, and treasury values have to collapse. I think there are actually quite a few scenarios that could derail those assumptions, and those of us prone to rational thought would do well to remember that the folks in Washington don’t share that habit. We are often tempted to assume that the politicians would “never” do something that seriously threatens the very sovereignty of the nation, when in reality they have shown us again and again that they are willing to take just about any risk in order to achieve their own short-sighted goals.
So the real reason I started this thread was to get a discussion going about what could go wrong in the short long-bond trade, which so many of us are in, either through the TBT ETF or other instruments. Aside from the scenarios I’ve described above, what else could go wrong?
Sounds like Hugh Hendry might be long on short term paper with options.
Not certain, but that was my take after watching the debate.
Greece is a miniscule part of the Euro’s composition and I’m amazed at the amount of money flowing into the dollar. I wonder how much of that is the (perceived) flight to safety and how much of it is the result of the shadow banking world of derivatives being settled in the reserve currency.
I tend to lean with Puplava and CM’s train of thought.
This is one market I’m only going to guess at with PMs, a lot can and likely will happen before the house of cards collapses.
I guess if foreign demand falls off the cliff they will confiscate the 2 trilion or so tied up in 401s and IRAs and use that to substantiate the BS column in the BS ledger called “Other Households” purchasing treasuries. That should give them 6-12 months more of pretend time.
What a pathetic joke.
After that I see rates spiking, which will bite them in the deficit tail making the debt on the debt look like a dog chasing it’s tail.
Faber and Celente are sounding more and more alike in the WWIII routine each day. What a wonderful world.
“I am hugely intellectually bullish on Treasuries. I am long. I fear the end of QE, the money funds are making on the [curve], I am aware of the issuance, I am aware that the States is going to have to sell $2.5 trillion of this stuff. But that’s the marketplace – the marketplace disseminates the bad stuff. I think there is a lesson in Japan. You think they are going to succeed – Mark [Faber] thinks they are going to create inflation. The precedent of Japan suggest that if you allow leverage in your society to breach a certain level, let’s call it 200 or 230% of GDP, then what happens is monetary policy doesn’t work, fiscal policy doesn’t work. They’ve had helicopters, they have distributed free money to their citizens, they have built bridges to nowhere and prices are falling and look set to fall further. My fear just now is that the community of risk is very short treasuries, and is very long risk: risk assets are the hedge against inflation. Now if something untoward happens, the gamma on that trade bankrupts you.”
Nothing is for sure or easy right now IMHO.
Here’s another scenario: Sovereign debt markets implode as what started in Dubai spreads to Greece, Spain, Portugal, Italy, Ireland and other places and perhaps takes all of Europe down in a burning heap of you-know-what. As bond investments in these governments are liquidated, they will have to go someplace else and the only market large enough for them to go to are US treasuries.
If that happens, the US will have no trouble at all bringing $2.5+ trillion to market this year. They may not even have any trouble auctioning off some 30-yr treasuries at ridiculously low rates. They never sell much on the long-end, at least never more than they can buy themselves through Primary Dealers in my opinion. That will leave 10-yr bonds and below, for which there would still be plenty of demand for, especially if Europe tanks.
Now, combine that with bubbles popping in Australia and China. If you believe China is the mother of all bubbles as Chanos and Hugh Hendry do, then the idea of the Yuan ever appreciating will have to be discarded, and their implosion will take all of Indonesia, Australia and Brazil down in flames. Japan will follow, perhaps voluntarilly, as the whole world will then be in a competitive currency devaluation scheme kamikaze style.
The US, despite all its mistakes, blunders, and stupified leadership on both sides of the political aisle, just might wind up continuing to hold the most sought-after currency after this is all over. I mean, if all the other currencies go down the tubes, there will be plenty of demand for dollars even if we do hyper-print, such that we will not experience hyperinflation. Of course, that will probably just mean that our politicians will not learn anything and we’ll be having this conversation again in 10 years or so.
My two cents.
I enjoyed your scenario very much, but I think there is much simpler reasoning to avoid shorting the long bond at this particular time: the bipolar nature of groupthink. Inflation/Deflation are more relevant as trading strategies than as macro-economic forces at this time. When the “group” fully commits to the deflation trade again, it will be time to scale into the short long-bond trade again.
As Hugh Hendry said, the politicians and central bank big-wigs are just muppets in this environment. Economic policy is not the factor in markets that it once was.
Before I risk any money, I am waiting for some signs that higher rates might be in play. Big money and the masses see California kick the can down the road over and over again and nothing really harsh has happened to them yet….nor Michigan….nor Nevada….nor massively underfunded pensions anywhere….etc. Until someone…ANYONE….has to actually take a hit for this debt bubble, then I dont see rates doing much. I know several people still in homes 8+months since the bank said they would be out on the street. No one has yet paid the fiddler.
In this moronic game of musical chairs, until I hear the music stop and see an actual consequence for excessive debt, I cant bring myself to short the US Bond. What am I looking for? I am looking for any state or national government to default on its debt payments. This would be a sign that printing money (IOUs from California for example) are no longer accepted, or that more debt or exentions of debt are not possible and that someone, somewhere, has finally hit a wall with huge debt. I am looking for Union or other pensions to fail to pay, and a court backing that failure to pay as legal under some bankruptcy ruling. I am looking for a massive public entity to shut down and, even in the face of pubic outrage and potentially massive lawsuits, to stay shut down as there is no money left anywhere to keep it open. I am waiting for the banks to puke out the shadow inventories and kick delinquent owners out.
Japan still has not stopped, and that says a ton. California still has not…amazing. How much further can we go? Maybe years and years! Maybe this week! I do know that I am shocked how much further a government can extend than individuals. Until that limit has been demonstrated in modern finance (global system interconnected with our currnet rate of transations/internet access), I will wait and watch with my jaw on the floor.
My best guess is that at some point, public pressure to keep services going, pensions paid, etc will have to yield to the fact there is no money. At that point, my best guess is a brief, shocking deflation (deflation in Japan is happening…maybe thats an indicator to look at). If deflation takes hold even a little, shadow inventories will be puked out. My best guess is that hyperinflation cant happen as long as the printing press money is not making it into the hands of the masses (its not anymore). And so, my guess is that rates stay near zero – which in deflation means the real rate of return is much much higher – and closer to historic norms.
In fact, maybe the “smart” big money and current rates are saying just that: Debt cant increase past some tipping point, at which point it stops, and deflation takes hold.
Waiting for a sign, and fully aware that the change may happen so fast that waiting might make me too late. While I wait, I continue to become more self sufficient – the lowest risk investment I know of!
Well my short position in 30-year treasury futures has been the largest notional exposure in my portfolio for more than a year now, and I find myself getting ready to at least temporarily abandon this trade and pare the position down to about half its current size, eating a significant loss in doing so. Since I find that there are some really smart people on this site, I’ve decided to post my thoughts and rationale here. I always welcome critical feedback, particularly from the several very experienced investors I’ve come to know on these forums in the last year and a half.
Here’s my thinking.
The rationale for the trade remains strong, but the risk of a big move up in T-Bond prices before the big drop has become too great.
I remain as certain as ever that the market has unwittingly morphed the infamous flight to safety trade into what I half-jokingly call the flight to stupidity trade. By that I mean that when markets get volatile, institutional investors bail out on “risk assets” and move to what they perceive to be the safest asset on earth. Shockingly they continue to ignore the obvious evidence that U.S. Treasuries are no longer the safest investment on earth, and they continue to target these securities in safety trades.
So I’m absolutely convinced that U.S. Treasuries are going to tank, big-time, at some point. But it looks like a lot of other asset classes including sovereign debt of other nations will collapse first. It just blows my mind, but it appears that the market is going to continue to do the stupidest thing possible, and react to fears about small countries that can’t service their sovereign debt by piling into the sovereign debt of a much larger country that is just as broke, and just as unable to repay the debt in real terms. That last point is critical because it appears to me that a shocking number of market participants just don’t comprehend the distinction between repayment in notional terms vs. real terms. They seem to think that “The U.S. can’t default because it has a printing press and controls the reserve currency”. That’s true, but all it means is that investors will feel the effects of a default in real terms, but it will be disguised by payment in full in notional terms. But the real difference is that when we’re talking about the United States, too big to fail is no longer the operative phrase. The United States is too big to bail. Nobody anywhere has enough capital to effect a bailout of a U.S. sovereign debt crisis, so when it goes down it’s going to go down big-time.
The scariest part of this (to me) is that the short long-bond trade has become very crowded. Here’s the specific scenario that I fear:
- Greece continues to disintegrate, then the next PIIGS country starts to crumble as well. Institutional retards do the stupidest thing possible and bail on what they perceive to be “risk assets” and pile into U.S. Treauries up and down the yield curve.
- Investors finally wake up to the obvious and realize that the “recovery” is a sham, and that other than stimulus money temporarily distorting the statistics, there is no recovery. A steep correction or even a crash in equity markets ensues.
- As investors bail out of equity markets in droves, they do the stupidest thing possible and follow the flight to stupidity, buying ever more treasuries. Think about it: If there is a treasury funding crisis, the Gov’t might even intentionally let the equity market correct sharply for the simple reason that they know the money will land predominantly in treasuries. They want to prop up both equity and treasury markets, but if they can’t manage both they will almost certainly protect the treasury market over the stock market.
- As all the institutional money flows into treasuries in the flight to stupidity, treasury prices move considerably higher, resulting in a short squeeze. The short long-bond trade has recently become very crowded, and my gut sense is that most of the shorts came late to the party. They’re already feeling the pain from the big move of over 3 big handles up in the last two weeks, fueled primarily by Greece fears. I predict that most of the shorts don’t have another 3 points of staying power. I fear we could be perilously close to the squeeze point now.
- The big move up resulting from a short squeeze calms the concerns of most about the stability of treasury markets. The flight to stupidity continues in earnest.
It always sucks to eat a big loss, and after the 3-point move up in the last two weeks I’m already out more money than I care to admit here. But I think I’m going to eat the loss here at 119-8 (on the March contract), cut the position in half, and wait and see what happens. I won’t be surprised if the June contract (now strongly backwardated to about 117-24) moves up to 125 or so before reversing.
Critical feedback on my rationale is welcome and appreciated.
Its tough to fault any of your thinking. Let me add that almost all institutional money has to be almost entirely invested at all times. Further, the vast majority of institutional money is confined to debt and equity markets. A move to US treasuries may not be stupid in that regard, rather its the best legal choice these poor bastards have. Most cant touch commodities (except for buying companies with exposure to that commodity – and the divergence between underlying commodities and their equity sectors has been insane lately). I know this might not help ease any pain, but at least its easier to be less emotional or frustrated when thinking of why money is flowing the way it is. Its important to know the limitations of those you are trading against.
I think your analysis is dead right re many other countries being far worse off than us, and while their demise might lead to ours, there will likely be a flight first to US treasuries before they meltdown. I feel this is true of gold too. While I might like it longer term, I think short term if there is a worldwide asset collapse gold has a good chance of moving down only because so many institutions will be forced to sell some of everything in order to raise cash. Again, this is a flaw of leveraged money – if the markets move down, they are forced to sell no matter what the price, and that leads to silly and overdone moves down. Of course, that means opportunity for those in the right situation.
So, while treasuries going up and gold going down seem completely counter intuitive, and perhaps moronic, these moves are likely the result of how money is set up and forced to move rather than how it would like to move. Its amazing to think of how much money is managed by people whose hands are so tied they cant make the decisions they would like to when it really counts – – rather they must stay almost entirely long. Or, they must raise cash and sell when they dont want due to redemptions (or margin calls if they are leveraged). Its not always the stupidity of the managers, rather its the stupidity of the rules that surround most money invested at investment firms!
I’ll finish with one of the best trading rules I have ever heard “If a market is moving in ways that dont make any sense to you, get out, protect your capital”
Critical feedback on my rationale is welcome and appreciated.
I don’t know nearly enough about the markets to offer up any *useful* feedback, except to say that these days, it doesn’t seem as if there is any safe place to park one’s money (apart from collapse hedges which don’t really earn any returns, but are simply intended to hold some value).
Viva anyway — Sager
Thanks very much for the thoughtful comments. Your words of wisdom about people doing apparently stupid things not necessarily being stupid, but rather just being constrained by their mandates was particularly insightful and helpful to me. As a private investor I am not used to thinking in terms of what I’m allowed or not allowed to do, so I easily jump to the conclusion that people doing things that don’t make sense to me must not be terribly bright. Your explanation that they are actually doing the smartest thing within their limited set of options makes far more sense, and reminds me how quick I sometimes am myself to jump to errant conclusions.