I can’t seem to track down who said it, but one of the guys I follow on Twitter had an amusing anecdote about the recent carnage in the bond market. The tweet conveyed something to the effect of:
I am at a wedding with lots of plugged in macro hedge fund managers, and everyone is swapping horror stories about which Eurodollar contract they are short.
For those who don’t know, the Eurodollar contract has nothing to do with the Euro currency and is instead a way to speculate or hedge US dollar 90 day time deposits. It is generally the most liquid short term fixed income instrument in the world.
If you wanted to speculate on short term rates being raised sooner rather than later, then shorting Eurodollars would be one of the most efficient direct methods.
Which is exactly what every hedge fund manager and his dog have been doing.
Ever since the Fed finally convinced the market that they were not going to taper the taper, speculators have been piling on the short Eurodollar trade. The logic was that if the Fed was determined to continue with the taper, then the next step would be for them to raise rates. Given the absurdly low levels of short term rates, shorting Eurodollar contracts seemed like a good risk reward.
Have a look at the speculative net position in the Eurodollar contract over the last few years:
Eurodollar Speculative Open Interest Net Position</a> </div></p>
The tweet from the trader about all the macro hedge fund managers being short Eurodollar contracts is well supported by this chart. The speculative open interest is massively skewed to the short side.
What is interesting is that there was also almost no short covering during this recent rally. You would think that the pain caused by the rally would have caused a little more panic amongst the shorts.
The December 2016 Eurodollar contract has rallied 60 bps over the last month.
ED Jun 2016 Contract</a> </div></p>
This has been a massive squeeze in the market’s expectations of short term interest rates, yet the speculative short position is still sitting at record highs.
I would have expected a lot more short covering…
As I tried to understand the lack of short covering, I came to a realization that the specs have actually covered a lot of their short bond exposure, but they did it at the long end of the maturity spectrum.
To understand what I mean, let’s have a look at the net speculative position of the various Treasury Bond contracts.
First up, the Five Year:
US 5 Year Treasury Bond speculative position</a> </div>
The hedge funds are net short five year contracts, but they did cover some during the last week.
As you go out the curve though, the speculative position gets more and more long. Here is the 10 year:
US 10 Year Treasury Bond speculative position</a> </div>
The 10 year net speculative position is no where near its low.
The 30 year is in fact even net long:
US 30 Year Treasury Bond speculative position</a> </div>
Not only are the specs net long 30s, but the net position is sitting at its highest level in quite some time.
I don’t really understand the logic of this thinking, but the specs are sitting with a massive short position at the front end of the curve and are at the same time buying long bonds by the fistful.
They are in essence betting that the Fed will tighten too aggressively and push the economy back into a deflationary slide.
Even though the Fed has repeatedly told the market that they will be slow to raise rates after the taper is complete, the market does not believe them.
This last month’s bond market squeeze was not led by the short end of the curve, but instead was the result of the longer end receiving massive inflows.
Have a look at the 2/10 year spread:
US 2/10 Treasury Yield Spread</a> </div>
The 10 year bond rallied much more than the 2 year, pushing the curve to new flat levels for this move.
Although the 5/30 did not move down to new lows, it has also been sagging over the past few months:
US 5/30 Treasury Yield Spread</a> </div>
Neither of these moves are indicative of a market that believes the Fed’s policy error will be to leave rates too low for too long.
Rather, the specs are venturing out the yield curve in anticipation of a policy error by raising rates too fast.
Now the real question we need to ask ourselves is whether the specs are once again getting it wrong by buying the long end. Was this just a short covering rally in which the specs make a bad trade all the worse by hedging their short front end bets by buying the long end?
Since I believe that the Fed’s mistake is that they are going to leave rates too low for too long, then I am inclined to think that the specs are digging themselves a bigger hole.
I understand that there are some hawkish members of the Federal Reserve board that are making some rather loud noises about raising rates quickly. But those members are always going to be hawkish. It is like buying gold because Eric Sprott thinks it is going up. He always thinks it is going up, so the forecast is meaningless. The Fed hawks are always going to think that the monetary conditions are too loose because, well, they are. But does that mean the Fed actually has the will to do something about it?
Although I fully accept that the Fed is going to taper and wind down the QE programs, I do not think that you can translate that into a relatively hawkish Fed. The reason they are winding down QE is because it is not effective at accomplishing the Fed’s goals. The Fed rightfully understands that QE is not trickling down into the real economy like they wish.
It took a couple of decades, but I think the whole idea of trickle down economics has finally being discredited.
But that does not mean that the Fed has suddenly found religion about sound monetary policy. No far from it. They are in fact even more determined to right the wrongs created by the 2007/8 crisis. They understand that their policies have disproportionally helped the very people who caused the crisis.
The Fed will continue to be extremely easy for some time to come. The idea that they are going to raise rates aggressively is absurd.
I might buy the argument that the end of QE3 will cause financial asset deflation to return. For that reason, it would make sense to buy bonds. But if that does happen, then the short end of the curve is going to be pegged to zero (or even negative) for some time to come. It would make more sense to buy 2s or 5s, then 20s or 30s. In an “end of QE causing a deflationary sag” environment, it makes no sense to short the front end and buy the long end.
The only reason I can see for the specs’ current positioning is that they are betting on the Fed being too tight too early.
I think that this will once again prove to be a painful trade for the specs.
I am hanging tough with my long 5/30 steepener trade. It hasn’t worked yet, but I think this latest rally in the long end of the bond market is the result of specs making a mess of their position. At a certain point will come a time to press on the open wound of these speculators. Right now the onslaught of money chasing the long end of the bond market is pretty frightening, but there will reach a time where you have to plug ’em. We aren’t there yet, but it is coming soon.
China – is the worst behind us?
There are still a lot of China bears amongst the macro hedge fund community. Although a couple of years ago, I was a huge China skeptic, I now feel that the problems are too well publicized to not be fully discounted by the market. Who doesn’t know the stories about the ghost cities? Or the absurd amount of extra office space? Or the hoarding of base metals in some sort of ponzi like financing scheme?
When famed short seller James Chanos first highlighted China as a great short opportunity he was met with all sorts of derision. Even though China’s economy and market have been falling steadily for the past couple of years, only now have market pundits decided it is time to short China.
Although I am scared about the huge misallocation of capital that has occurred in China, I think the surprise will be that China doesn’t shit the bed as badly as market participants anticipate.
I have been on the lookout for signs that the Chinese authorities have realized their tightening efforts have gone too far.
One of the indicators that I follow is the spread between 2 year Chinese swaps and 2 year government bond rates. Now this is a fledging market, so I am not sure how much you can rely on this indicator as a true measure of credit risk, but I think it is still worth watching.
China 2 Year Swap / 2 year government bond spread</a> </div>
At the beginning of the year, as the Chinese government was steadfast in trying to usher in a slow down of the speculative areas of their economy, this spread spiked to new highs. This was the result of the removal of liquidity and the worry about the credit worthiness of the financial system.
However, this spread has since completely recovered and has actually ticked at a negative rate.
This is the result of the recent change of policy by the Chinese government. The great Kiron Sarkar weekly research piece summed it up best:
Premier Li suggested that there would be more policy easing to counter the slowdown in China and to provide more credit to smaller companies. The central bank has been providing additional liquidity and, in addition, has allowed the Yuan to weaken. Furthermore, the Ministry of Finance reported that it would speed up spending to support economic growth, which they admitted was under pressure and should not be underestimated. The increasing concerns expressed by the central authorities suggests that the slowdown in China is much greater than suggested by the official data. Whilst the central authorities have been reluctant to increase their stimulus programme, they may well be forced to do so. Furthermore, the Chinese cabinet announced that they would cut the reserve requirement ratio for certain banks who have made loans to rural borrowers and small companies.
The Chinese government has recognized that it has slowed the economy too much and is now in the process of restoring the much needed liquidity. Given the market’s preponderance for Chinese short themes, I expect that this will be one of the next shoes to drop against the hedge fund community.
Beware of the smooth power point presentations by hedge fund moguls about why China has to crash. They might be logical and well thought out, but I think they are late…
My suggestion is to apply the Friedland rule. One of my brokers at CIBC has this great rule about buying any of famed financier Robert Friedland’s stories. You see, Friedland is such a great promoter that after one of his presentations, the temptation to run back to the office and load up the boat is huge. People rave about Steve Job’s presentation skills, but many don’t know that he was actually roommates with Friedland and learned the techniques from him. My CIBC broker’s rule was that you needed to wait two days before you could buy the Friedland story. If at that point, you still liked it, he would allow himself to buy the stock. He figured the Friedland effect had probably worn off at that point. And more often than not, in the clarity of a couple of days of independent thinking, he would realize that the Friedland stock was probably not as compelling as he originally believed.
So, please apply the Friedland rule to any short China presentations…