Shorting US bonds

M

mtzianos

In this thread we'll attempt to make a case on a short trade of US Bonds. We can also discuss various way to trade it (e.g. short futures, short TLT ETF, ED calendar spreads, reverse funds etc)

This is a followup to the thread at http://www.elitetrader.com/vb/showthread.php?s=&threadid=43253 on suggestion of another contributor.

Quote from BlueHorseshoe:

Why not you recycle your posts on this thread into a "Shorting Bonds" Journal?? I have much to contribute. Of particular interest are discussion of yield curves in US and UK (note UK inverted yield curve, the Kontratieffe (sp?) cycle, global rising inflation & asset prices, CPI/CPE, etc.
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Everyone, please feel free to share your ideas. As this is obviously a longer term trade, I think that fundamental issues should be given some attention.

In a few words, this trade is based on the following premises:

1. The reason why long-term bond yields are held at these levels, is buying by Asian Central Banks (BoJ and BoC) to maintain a peg between their currencies and the USD. This buying is regardless of market value or economic outlook. The continuation of this practice is questionable.
2. The pressure on the yields of long bonds is also due to the "carry trade", where big players are borrowing at short-term rates and investing at long-term rates. "Neutral" FedFunds rate is assumed to be around 4% (even with "engineered" CPI numbers). If Fed fails to promptly raise STIRs it'll do the same mistake BoJ did in late 80s thereby planting the seeds of the economic woes that continue to plague Japan today (pls refer to last link, the one about Japan).
3. US administration will probably "inflate away" the debt (as suggested by many prominent figures, e.g. Warren Buffet). Actually monetary / credit inflation is manifesting itself in many ways (e.g. CRB rally, housing bubble).

Some background reading list:

US Gov inflation con job
http://www.pimco.com/LeftNav/Late+Breaking+Commentary/IO/2004/IO_Oct_2004.htm
http://moneycentral.msn.com/content/P92951.asp
http://www.safehaven.com/showarticle.cfm?id=2407
http://www.safehaven.com/showarticle.cfm?id=2400

It's pretty obvious that real inflation is nowhere near the official numbers.


Macro outlook
http://www.morganstanley.com/GEFdata/digests/20050103-mon.html
Note: Roach/MS says that private buying is even more than FCB buying (I assume he has his facts straight, but maybe someone can confirm?)

Roach: "In the 12 months ending October 2004 (latest US Treasury data available), net foreign buying of long-term US securities totaled $850.6 billion, well in excess of the cumulative current-account deficit of $603 billion recorded over the four quarters ending in 3Q04. Yes, there was an increase in the share of dollar-denominated assets purchased by foreign central banks, from 18% to 27% over the past year; this was a conscious policy choice, largely aimed at preventing Asian currencies from rising and thereby impeding the region's export-led growth dynamic. But the bulk of the flows still came from non-US private investors seeking return and/or security in dollar-denominated assets. And nearly 97% of the net flows were concentrated in fixed income securities, as foreign buying of US equities remained de minimus. Little wonder US interest rates stayed so low. Needless to say, if this voracious foreign appetite for US bonds remains intact in 2005, another interest rate surprise could well be in the offing. I doubt it, but stranger things certainly have happened."

Japan intervention issues
http://202.221.217.59/print/business/nb05-2004/nb20040503jp.htm
Note: Apparently, through its intervention practices, BoJ is now sitting on $800bn of dollar securities. BoJ's balance sheet is 30% of GDP. And "paper losses" of these positions are estimated between $70-$100bn.

 
Intervention over time. BoJ already amassed $800bn "risky assets" which value is ~30% of Japan's GDP

"Paper losses" (due to dollar slide) of those holdings were estimated at $70bn in April-2004 (should be about $100 billion at the end of 2004 assuming no change in positions)

The Japanese taxpayers will pay the bill, if it goes sour.
 

Attachments

Making the case for shorting US bonds is easy, and you make it eloquently and succintly. Making money doing the actual shorting, however, is a different matter entirely. Normalized LT/ST spreads are only now returning to historical norms, and since these macro trends generally overshoot, history says an actual inversion is quite likely. Bonds have been slaughtering early shorters for a long time now, I fully expect one more pile of broken and bloodied bodies.

Good luck!
 
Quote from Random.Capital:

Making the case for shorting US bonds is easy, and you make it eloquently and succintly. Making money doing the actual shorting, however, is a different matter entirely. Normalized LT/ST spreads are only now returning to historical norms, and since these macro trends generally overshoot, history says an actual inversion is quite likely. Bonds have been slaughtering early shorters for a long time now, I fully expect one more pile of broken and bloodied bodies.

Good luck!
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Yes, successful shorts need to be very skilled, and cognizant of the landscape. Shorts need to control their leverage and position for the long term, pyramiding gains over months and years. Daytraders will not survive - in truth they never do.

I would expect another 'pile of broken bodies' if the US consumer rolls over. Actually, I expect rising inflation expectations and interest rates to result in the US consumer rolling over. But that will only slow the rise of inflation, not end it.
 
Rydex Juno and ProFunds Rising Rates Opportunity Fund have gathered a lot of assets over the past year and a half yet long-term yields have not gone up like everyone predicted so those people have not made any money if they've been just sitting in those funds. I'd like to see everyone give up on the rising rates play -- then it may be time to get in!
 
Quote from formikatrading:

Rydex Juno and ProFunds Rising Rates Opportunity Fund have gathered a lot of assets over the past year and a half yet long-term yields have not gone up like everyone predicted so those people have not made any money if they've been just sitting in those funds. I'd like to see everyone give up on the rising rates play -- then it may be time to get in!
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Numbers are fine, as long as we maintain the perspective. Have a look at the numbers of the leveraged carry trade (which will have to be unwound at some point, as FedFunds rise)

http://www.inginvestment.com/news/bondnotes/bondnotes_march04.pdf
http://slate.msn.com/id/2097084/
 
Quote from Random.Capital:

Normalized LT/ST spreads are only now returning to historical norms, and since these macro trends generally overshoot, history says an actual inversion is quite likely.
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RC, thx for the feedback. Personally, I like to listen to everyone's views.

Some info for consideration:
http://www.safehaven.com/article-2450.htm

If he got his facts straight, FCBs are not directly involved in setting the current "artificially low" 10yr and 30yr yields. FCBs buy short-term issuance only (makes sense afterall, they'd be nuts to take all the interest-rate risk, on top of the currency risk)

So, let's talk about YC inversion...

If indeed FCBs are involved striclty in ST, then (assuming that one agrees that the current LT yields aren't "fair"/ "logical" wrt to inflation and expansion in money and credit etc) the current LT yields are probably the result of the curve-flattening carry trade. This is performed by dealers and hedge funds, using high leverage.

The fact that Fed has been so "predictable" telegraphing its action well in advance, it seems that this carry trade has been a "sure thing" ( as Roach calls it in http://www.morganstanley.com/GEFdata/digests/20050110-mon.html ) trade for dealers/funds for years. Recent 5 yr the funds playing this trade have grown parabolically (to trillions).

So, assuming the LT yields are due to carry trade, if Fed pushes ST into neutral territory (4%-4.5%), wouldn't it cause an unwind of the carry trade? How could the YC possibly invert before the unwind of carry trade can happen?

I think the carry players are assuming that Fed won't raise quickly enough. This would be compatible with the idea that US wants inflation (to wipe out part of its debt, simply debasing the currency won't be enough) so it won't raise quickly enough.

Let's also discuss instruments (e.g. ZB or GE spreads). If markets somehow do wake up to the fact of 6+% inflation (or intervention stops or whatever), then logically, the riskiest instruments (LT) should have most of the selling.
 
Reading through Kindleberger's "Manias, Panics, & Crashes" today. What he says about the Japan bubble sounds extremely similar to what we are seeing in the US.

Near the end of Chapter 7 he describes how Japan's lowering of their funds rate fed their bubble, and how inflation was not reflected in consumer or producer prices but in ASSEＴ PRICES. An excerpt:

"Most central bankers choose price stability as the main target of monetary policy, whether it be wholesale prices, the consumers' price index, or the gross domestic product deflator is not a critical issue. If, however, the explosion of a bubble in stocks and/or real estate can affect bank solvency in general, there is a basis for saying that central bankers should keep an eye on asset prices too. In one view, asset prices should be incorporated into the general price level because, in a world of efficient markets, they hold a forecast of what future prices and consumption will be. But this assumes that asset prices are determined within a narrow range by fundamentals, as they often are to be sure, and will not be affected by herd behavior, leading to a bubble that will ultimately burst."

To paraphrase Greenspan back in November (?) 'Anyone who isn't prepared for much higher interest rates is determined to lose a lot of money.'
(Maybe someone can help me w/ that quote.)

In short: Short Bonds.
 
Quote from BlueHorseshoe:



To paraphrase Greenspan back in November (?) 'Anyone who isn't prepared for much higher interest rates is determined to lose a lot of money.'
(Maybe someone can help me w/ that quote.)

In short: Short Bonds.
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I interpreted Greenspan's comments as quintessential Fed "jaw-boning". He was trying to talk yields higher.

Greenspan needs yields on the long end to move higher lest the yield curve flatten (invert?) with short term rates still artificially "low".

Too many assume we've successfully navigated out from under the natural deflationary forces of globalization, etc.

Hardly.

And pushing the "zero-limit" at the long end is still a very real possibility.

I’m not convinced it happens but I don’t think Greenspan is being as “honest” as we might like to think.
 
Quote from LaSalle:

I interpreted Greenspan's comments as quintessential Fed "jaw-boning". He was trying to talk yields higher.

Greenspan needs yields on the long end to move higher lest the yield curve flatten (invert?) with short term rates still artificially "low".

Too many assume we've successfully navigated out from under the natural deflationary forces of globalization, etc.

Hardly.

And pushing the "zero-limit" at the long end is still a very real possibility.

I’m not convinced it happens but I don’t think Greenspan is being as “honest” as we might like to think.
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yeah man, good post. bond market act like deflation big enemy while masses catch onto inflation and think that the big problem.

Mr. Zen
 
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