A PATHETIC ATTEMPT TO JUSTIFY A BOND SHORT

2017-09-05 10pm EDT  |  #bonds #Fed #ECB #Global PMI

For bond bears like myself, today was an ugly day. Fixed income prices ripped higher, egged on by continued escalations of the North Korea situation with an added dose of poor economic reports for good measure. Some dovish Fed talk was the icing on the cake, and there was no mercy shown for bond shorts.

Although I am licking my wounds, the hedge fund community is relatively well positioned for this move.

The long end of the bond futures curve has rather large net long speculative positions.

Hedgies and other speculators have more than 284,000 net contracts of 10-year futures.

And they are net long 56,500 of the longer dated contract.

So yeah, I am probably the only putz that wasn’t rooting for bonds to continue screaming upwards today.

And I have to admit, technically, the chart looks great.

Notes are breaking out, and it’s tough to come up with a reason to sell ‘em.

But let me give it a try (and I realize this sounds suspiciously like I am defending a losing position. Point taken, and if you want to ignore the rest of my entry, I completely understand.)

The investing community is piling into fixed income on a flight-to-safety bid due to the North Korea tensions. Ironically, as tensions heat up, the Japanese Yen rallies as it is a funding currency, and the unwinding of carry trades causes Japanese currency strength.

The Yen’s movements have been tracking the US 10 year yield almost tick for tick recently.

It seems crazy that the country which North Korea is lobbing missiles over is experiencing currency appreciation, but there’s no sense arguing with the market - it is what it is.

Therefore, if you believe the North Korean situation will escalate from here, then, by all means, load up on treasuries. That’s the right trade. Yet, I just don’t see war breaking out, and I suspect North Korea will slip off the front page before you know it. There are no real military options, so the idea of Trump and the rest of the world doing anything more than increasing sanctions is a non-starter. Kim Junior will keep testing his missiles, Trump will keep warning him that he will face severe consequences, and nothing will change.

The devastation from Hurricane Harvey is more on my mind than North Korea. Houston is the United States’ fourth biggest metropolitan area. The damage from the flooding was unparalleled. I don’t see how this doesn’t tip the Fed into erring on the easier side of monetary policy. Whereas I previously believed the Fed might surprise markets with a December hike, this new input tilts the odds of the Fed standing pat.

But shouldn’t that be bullish for bonds? A less aggressive Fed would at first blush appear to be bond friendly.

Yet is it?

Houston will require a tremendous amount of aid to rebuild. Money will be spent. Resources will be diverted. At the same time, the Fed will leave money easier than would have otherwise been the case.

This all sounds inflationary. And what is a bond investors’ biggest worry (apart from default)? Inflation.

Although speculators are long 10 and 30 year treasury futures, they are actually net short the 2 year.

Hedgies are betting the Fed will raise rates, slowing the economy, and cause the curve to flatten.

And so far they have been bang on correct! The US 2-10 year Treasury yield spread has collapsed, and is sitting near the lows.

Maybe the hedgies will continue to be correct. Maybe the curve is about to flatten even further.

But over the years I have learned that when hedgies all think one thing, it is time to think something else.

The Fed will err on being easy, but will continue with their plans to wind down the balance sheet. On the other side of the Atlantic, the ECB is in a real predicament as they are running out of bunds to buy, and desperately want to taper their QE program. How can they get out of this mess without disrupting the economy? Through firm forward guidance that guarantees short term rates will not be raised.

In my books, I think both the Fed and ECB will be easy on the short end, but hawkish on the long end. This will occur through either quantitative tightening (Fed), or the reduction in the amount of quantitative easing (ECB). In both cases, I think that means a steeper yield curve.

And it’s not like the global economy is having troubles. Look at JP Morgan’s Global PMI index versus the US 10 year treasury yield.

Bonds are discounting an economic weakness that is simply not there.

Yet my most compelling argument in favour of shorting bonds has to do with supply. Too many investors forget that the amount of bonds in circulation is not static. As prices and economic circumstances change, bonds are either created or paid down. For too long after the Great Financial Crisis, private individuals and corporations were hesitant to borrow. That is why the government needed to step in and take up the slack.

That has changed over the past couple of years. Have a look at this chart that shows total corporate debt issuance every year since 2003.

This year we hit a new record amount of debt issuance (blue line).

But what’s really important is that since coming back from summer holidays, corporate issuers have assaulted the market with a barrage of new deals.

Look at what was announced today:

There is a famous market saying, “when the ducks quack, feed ‘em!” Well, corporate issuers have taken that to heart.

They are about to fill the bid in the bond market like a butter tart.

Although many market pundits are getting all bulled up on bonds, I am not so sure that this wise. I see a Fed and ECB that will be friendly to the short end of the curve, but both Central Banks’ actions might weigh heavily on the long end. The speculative community is heavily long far dated paper, while short the front end. It wouldn’t take much for them to ring the register on their trades. And in the coming days, if North Korea manages to keep their missiles in their pocket, we could see a bunch of supply hit the market that might be the trigger for this unwind.

There you go. A short’s desperate attempt to put a bearish spin on this manic squeeze into fixed income. Pretty pathetic, eh?

Thanks for reading,
Kevin Muir
the MacroTourist