One of the big problems with the Fed’s ZIRP (zero interest rate policy) is the fact that it has sent a lot of investors out the risk curve. Many of these investors have bought high yield and junk bonds in an attempt to pick up a little yield. But in a lot of cases, these products are not suitable.
This move out the risk curve has been a long grinding affair. In the initial stages of the Fed’s financial repression, many investors held out, hoping that the ZIRP would be a limited time offer. However as the Fed has continued with their insane policies for the last 4+ years, investors have slowly accepted that to pick up any yield at all, they have to venture out the risk curve.
These investors are in not in these products because it matches their risk tolerance. They are in these products because the Fed has given them no choice if they want to earn any yield at all.
This mismatch of risk tolerances is a disaster in the making. As it becomes clear that the Fed is lifting off ZIRP, these investors are going to abandon their high yield and junk bond positions.
In fact this has probably already started. The outflows from this sector has dramatically increased during the last month.
The recent run of outflows is one of the longest streaks over the past couple of decades. Yet so far the price has actually hung in there pretty well.
When the Fed reverses course and actually starts raising rates, this is going to get really ugly. The decline of the last couple of weeks might have felt scary, but in the big picture, this was just a slight hiccup.
From a timing perspective, until this summer, predicting the top was a tough call. These bubbles go on until they stop, and trying to time the top is always a fool’s errand.
But the recent massive outflows, along with the big break in price has given us the perfect setup to speculate that the top is in.
During the last month, we had the push lower, which was followed by this week’s rally which retraced half of the correction. If I am correct that the top is in, then we should roll over fairly shortly. It shouldn’t hold above that big support line for more than a day or two. So we can get short, using that level as a stop to trade against.
Yesterday I made a lot of changes to my portfolio. I bought some at-the-money December 2014 puts on both HYG and JNK. I covered almost all of my short US stock index futures position. To pay for the decay in the puts, I have decided to short some calls on the S&P 500. I still think the most likely scenario for stocks is a slight grind lower. A short call position should benefit best from that outcome. I also decided to short some more Eurostoxx futures as I am more and more convinced that Europe is repeating the Japanese mistakes of the 2000s.
Returning to an old friend
During the past month, I was lucky enough to side step the recent down draft in the precious metals. But that whole time I have felt a little naked.
Yesterday the precious metals seem to get a bid for no real reason. I have been waiting for a signal to get back into the position, and this was all I needed to return to the long side.
I still think the bigger picture is higher. With the move in Silver from $21.50 down to $20.00 we have shaken out some of the weak longs. It seems like a decent place to start accumulating a position again.
I feel more nervous being flat than I do being long, so I am going to follow the “minimizing regret” trading philosophy. I am more at ease with a long position, so that is what I am going to put on.
Pop and drop in bonds?
One of my favourite trades is what I have labelled the “pop and drop.” This where a security pushes up into new highs (pops), but then quickly drops back into the range. I then use the previous highs as a stop to lean against with a short position.
I was fortunate to catch the recent high in the stock market using this technique, and I am wondering if we now have a similar opportunity in the bond market.
The recent move into bonds has had a certain “panicky” feel to it. There has been a lot of safe haven buying because of geo-political turmoil. However, I believe we are about to enter into a massive bond bear market. Although this view was popular six months ago, many investors have thrown in the towel on the idea that the bond market will ever go down. It would be just like the Market Gods to put in a top at the very moment everyone has given up on the trade.
I am shorting some US 10 year Treasury futures, using the recent highs as a stop. I also want to short some German bund futures, but I am going to wait until the ECB finally succumbs to QE to put that position on.