First it was Bill Gross describing German Bunds as the “short of a lifetime.” Now we have his arch rival, Doubleline’s Jeffrey Gundlach recommending levering up another short German fixed income position 100 to 1. To be fair, Gundlach is concentrating on the front end of the curve, while Gross was talking about the ten year bund. But you have to give Gundlach credit, it’s a bold assertion. From Bloomberg:

DoubleLine Capital’s Jeffrey Gundlach said he’s considering making an amplified bet against German bonds to join a growing group of top money managers wagering against the debt after some yields turned negative…

“Let’s say you leverage up the German two-year 100 times, that’s a 20 percent return,” Gundlach said.

The gist of the argument is that when you short a two year bund with a negative yield, even if rates remain unchanged during that period, you still earn the negative yield. The trade has positive carry.

The easiest way to demonstrate this positive carry is to have a look at the futures market for the German Schatz Future – their 2 year note. This example isn’t exactly what Gundlach is recommending, but it illustrates the carry nicely.

The front contract is trading at a lower price than the further out contract. Absent a move in rates, there would be a natural decay downward. So if rates remained unchanged, you could expect to make 111.20 – 111.30 = 0.10 each quarter on this position. That is the positive carry that Gundlach wants to lever up.

The big assumption is that front end will not be pushed into even more negative territory. Gundlach is betting that the ECB will not lower overnight rates to minus 50 bps or even lower.

It is probably not a bad bet to make. I was thinking about the problems with negative rates the other day, and realized that if they pushed the short end too far into negative yields, eventually it would make sense for a bank to borrow a gazillion Euros (a technical term), take delivery of the loan in currency form, and then store it in some vault deep under a mountain. The loan would earn the negative yield. All you need to do is spend less than the loan amount guarding your currency. Right now 25 basis points is not enough to pay for all the security, hassle and risk associated with having a gazillion Euros in your vault, but there is probably a limit to how far the ECB can push the front end lower. They could limit the amount of currency issued, but the financial system really wasn’t made for negative rates and we have probably reached the limits of how far the ECB is going to push the front end lower.

Not only that, what if European economy pulls out of its deflationary dive? I have long held the view that Quantitative Easing is inflationary and that we can expect the yield curve to steepen. Although the long end hasn’t performed exactly as I would have predicted, what if my view is simply a case of my hedge fund buddy’s motto; “I am never wrong, my timing just sucks sometimes.”

I have been perplexed at the massive rush into bunds over the past three months. I consider this sell off over the past week as much more expected than the previous move higher. Everyone is busy trying to explain why bunds are puking so badly, but I think they are looking at the question backward. I find the previous move to 0.05% yield in the German 10 year bund way more bewildering. Yeah, yeah, I know… Many pundits will argue QE caused the move higher in bunds (lower yields). But QE is inflationary, and when you look at QE in the United States, it was actually bond unfriendly. My take is that the transmission mechanism in Europe is slower than the US. The outcome will be the same, it just takes a little longer to kick in.

Either way, proving that a stopped clock is right at least twice a day, I actually got this one right when I leaned short last week. I was nervous that Gross was going to goocher “my trade”, but it seems like the old man only helped it along. And then when Gundlach pounced on the short side, the bottom fell out.

I am trying hard to let my position cook. One of my greatest trading weaknesses is that I have such a strong desire to be contrarian, the moment investors start agreeing with me, I unwind the trade. A work colleague told me the other day that I don’t need to be contrarian on absolutely everything and maybe there is a time when prevailing sentiment will actually be correct. I thanked him for his opinion, and then told him that of course he thought that way, that is what everyone thinks, so it must be wrong…

I am really bearish on European bonds. I have been lucky enough to be skated onside relatively quickly, and although I did ring the register on a little bit of the position, I am sticking with the short trade.

The coming global bond bear market

But the contrarian in me can’t shake the feeling that too many hedgies are clamouring about the virtues of the short German bund trade and it is destined to disappoint. So yesterday when I covered some short Bunds, I replaced it with an increase in my short JGB position (Japanese government bonds).

Over the last six months the markets have experienced a collective belief that deflation was about to engulf our global economy. All fixed income has been bid way too high. We have had the Japanese government panic with a second QE program and the ECB finally succumb to the pressures and institute their own balance sheet expansion. Investors have assumed that all this monetary stimulus will not work. They have chased long duration fixed income assets as the “there will never be inflation again our lifetime” crowd has dominated investor psychology.

Well, as you might have guessed, I will take the other side of that trade. Inflation is coming. The great global bond market has just started.

Bill Gross is right that shorting German bunds with yields in the teens is a great trade. But so is shorting Japanese JGBs with yields in the 30s.

All fixed income is way too high, and it makes sense to find other bond markets to short that aren’t crawling with hedge funds.

There are more hedge fund tombstones from the short JGB trade than any other trade. For years, decades maybe, it was a perpetual favourite with the boys from Connecticut. But everyone has given up on the short JGB trade. My guess is that the time for the short JGB trade has finally come. I hope I am not being contrarian just for the sake of being contrarian…

Thanks for reading,

Kevin Muir

the Macro Tourist