Jun 15/15 – Extreme bond positioning wind down?

2015-06-15 9am EDT  |  #bonds #bund #Europe #Fed #Germany #Gundlach #Niels Jensen

One of my bigger failings as a trader is my tendency to be correct at turning points, but then giving up on the trade too early because it has moved “too far too fast.” I try to stick with it, but I find it difficult to be among the herd. As soon I notice too many people agreeing with me, I figure I must be wrong. This is obviously a dumb conclusion. During the meat of the move, the herd will be correct, and the proper time to be contrarian is only at extremes.

I am a long term bear on fixed income. The market’s obsessive worry about deflation is yet another example of investors hedging for the previous crisis. In the coming years we will look back at the negative yield deflationary panic and laugh. It will seem amusing that investors believed Central Banks would be unable to create inflation.

Yet along the way, there will be lots of ups and downs for the bond market. For nimble traders, there will be opportunities on both sides of the market.

Over the past couple of months, the bond market has been struggling. We have backed up 50 basis points in the US 10 year treasury yield.

The decline in the German bond market has been even more pronounced. The yield on the 10 year German Bund has exploded higher.

It is tempting to attribute this large rise in global bond market yields to the start of a secular bear market. And although I am weary of trading against the current trend, lately I have been taking stabs on the long side of the bond market. Now you might chalk this up to yet another example of the MacroTourist fading for no other reason than to be on other side of the herd. But before you come to that conclusion, let’s go over a great piece by Credit Writedowns’ Niels Jensen that makes a compelling case the bond market selloff is overdone.

In the post “Are bond investors crying wolf?” Jensen argues the recent decline is simply the result of a massive unwinding of long European debt trades.

Bond investors lost serious amounts of money in the bond market rout between mid-April and mid-May. One estimate puts total losses at approx. $0.5 trillion[1] - not exactly pocket money for most of us.

I am not sure anything fundamental has drastically changed, though. Real rates accounted for virtually all the increase in interest rates between mid-April and mid-May (chart 1).

As pointed out by Barclays in a recent research report, had the sell-off been the result of QE doing its job, i.e. improving economic fundamentals, breakeven yields would have moved much more. Hence the sell-off was predominantly an unwind of term premia - not the result of enhanced economic expectations.

Having said that, the EU economy did perform somewhat better than expected in Q1 and, as a result, deflation fears abated. In the months leading up to the rout being long bonds had become pretty much one-way traffic. So convinced were investors that the ECB would prolong the 35 year bull market in bonds that it had become the trade du jour. We don't know yet who lost the most, as few have announced results for the month of May, but it wouldn't surprise me if parts of the hedge fund community ended up with a fair amount of egg on their face.

And it’s not just Niels that has come to this conclusion. From Bloomberg:

This is shaping up as the worst quarter for sovereign bonds in almost 30 years.

The Bank of America Merrill Lynch Global Government Index is down 2.9 percent since the end of March. If it holds, it'll be the biggest quarterly loss since the third quarter of 1987. The selloff started in Europe as investors balked at record-low yields in Germany, where they were barely above zero for 10-year securities. It spread amid rising speculation the Federal Reserve was preparing to increase borrowing costs this year as the world's biggest economy improved.

"It seems very much as if it was extreme positioning being unwound," Simon Smiles, chief investment officer for ultra-high-net-worth individuals at UBS Group AG in London, said in an interview on Bloomberg Television's "Countdown" with Anna Edwards.

The deflationary scramble into European debt drove bond yields to asinine stupid low levels. Don’t forget about the crazy research calls that were littering the street during this period. This gem from Citi summed it up perfectly:

We think that the buying restriction means that large parts of the German curve converge towards -20bp.

To be clear - we are indeed saying that -20bp is a yield target now that will gradually extend along the curve. Both the Bundesbank and private investors are expected to motivate a more concentrated buying squeeze.

When the fever finally broke, the unwind was uglier than most expected.

So the real question is whether this unwind is the start of a new bear market in bonds, or just a violent correction in the massive bull market. To some extent, I don’t think we need to answer that right now. Either way, the bearishness towards fixed income has become overly prononouced for the short term.

Niels wisely observed in a previous piece:

"I don't expect interest rates to make a dramatic move upwards for many years to come. However, lessons from Japan have taught me that, even if rates stay comparatively low, they can easily move 0.5-1.0% over a relatively short period of time, and a 1% move in the wrong direction can do a lot of damage to the P&L."

I don’t know if I agree with him about the long term safety of rates staying low, but I definitely agree that it doesn’t take much for some real damage to be done to the P&L. This bond decline has started to feed on itself, and the backup in yields is not the result of improving fundamental economic conditions, but simply a correction in the extreme positioning.

I think the jury is still out about whether we have entered a new secular bear market in fixed income. In the mean time, the sell off is over done and if you stay nimble, you can trade from the long side. There will be a time to load up on the short side of fixed income, but I don’t think we are there yet.

Now maybe I am getting too cute. Maybe the bond market is smarter than all the indicators that show the economy struggling to regain its footing. Maybe we are about to experience a hockey stick breakout in economic activity. If that’s the case, then I will have no problem quickly flipping to the short side of the fixed income market. But in the mean time, I think the market is wrong to be so pessimistic about bonds. Just like the market was wrong to take 10 year bunds to 0.05%, I think the market is equally wrong to be leaning so heavily against US treasuries here.

And I will leave you with one final thought. Don’t forget that an overly aggressive Fed is not a problem for the long end of the bond market. If the Fed does indeed get more hawkish, that will cause the US dollar to rally, choking off economic growth, and causing inflation to sag. These are all bond positive developments. Gundlach said it the other day, and I completely agree with him – “the long end of the bond market wants the Fed to tighten.”

Thanks for reading,

Kevin Muir

the MacroTourist