It was recently reported that for the first quarter of 2016, dethroned bond king Bill Gross (whose crown was snatched by media darling Jeff Gundlach) achieved returns that put him in the top 10% of all unconstrained bond funds. Far be it from me to criticize the former monarch, but I would like to take a moment to examine Bill’s strategy.
Luckily Bill outlined it all out for us in a recent Bloomberg interview. I took the time to transcribe the important bit:
“[I am] positioned for rather static monetary policy. That doesn’t mean we don’t have one hike or so in 2016, but you position with a static position and what does that get you? 1.8% return on the 10 year US treasury for the next 12 months. That’s not very much. So rather than buying bonds and certainly you don’t want to buy bunds, German bonds that yield negative rates all the way out to eight years - you don’t want to do that.
What you basically do is sell volatility around the yield in order to take advantage at what I perceive to be a rather gradual interest rate hike in terms of the Federal Reserve. If it is gradual, volatility will be low and instead of buying it, you want to sell it and generate returns that way.”
Let me summarize Bill’s strategy:
- fixed income yields stink
- the Fed has promised everything will be ok
- sell insurance to all those worry warts who think otherwise
- finish in top 10 percent of bond funds
I earned my chops trading equity index derivatives at a big bank. We were perpetually short volatility. Bill, I get it. Coming in everyday with the theta wind (decay) at your back sure makes trading easier.
But I think shorting fixed income volatility to juice low yields is an especially bad idea. So much so, that all I can say is “bought from you Bill.”
The next big one
Maybe Gross is wise enough to know exactly how many nickels to pick up in front of the steamroller. He was after all a King.
But I think Bill is misjudging the potential size and speed of this steamroller. Over the past thirty years, all the real big nasty steamrollers have confined their travels to equity, credit and emerging markets. Black Monday, Michal Milken’s junk bonds crash, the tequilla crisis, the long term capital management debacle, the dotcom bubble and the 2008 doozy have all had one thing in common. None of these crises centered around the risk free rate.
You have to go all the way back to the late 1970s to find a period where risk free government bonds were the focus of a market event. The fact almost no one can remember when US treasuries went no bid is precisely why selling bond vol seems like such an attractive trade.
Do you remember Ben Bernanke’s 60 minutes interview? When asked how confident he was about keeping inflation contained, he responded 100%. I get it, he was the Chairman of the Federal Reserve, he has to say that. But we don’t all have to believe him.
And this is the real problem. Investors are convinced inflation will never return. All you have to do is look at the stupidly low nominal yields to realize the 1970s is the furthest thing from their minds.
And when you combine this complacency with a Fed who says they are committed to gradual rate rises, you get the sort of desire to pick up yield at any cost. Including selling volatility based on this promise.
I would rather lick the handrails of a crowded subway train than trust the Federal Reserve will be able to contain this massive monetary science experiment. World Central Banks have poured so much raw fuel into the financial system, someday, and I have no clue when, it will ignite and all those flimsy promises will be forgotten.
Maybe Bill will get out in time. Who knows? But it sounds a lot like Chuck Prince’s “we got to keep dancing” comment. This sort of reach for yield smacks of the final innings.
It’s not rich either
The really scary part of Gross’ vol sale is that implied volatilities are far from rich. It’s not like everyone is clamoring to buy bond protection. Have a look at the Merrill Lynch MOVE index. Think about this as the VIX for bonds:
When you examine the volatility over the past 25 years, the current reading is almost in the bottom decile:
Bill is shorting volatility at levels that are historically cheap at a time when risks are way higher than anytime in the recent past.
You would have thought Bill would have learned his lesson with the German bunds.
Last year as the German bund was approaching 0% Bill made a dramatic “short of a lifetime” call. It was a fantastic forecast and the bund ripped from 0.04% to over 1% in about a week (Bund bears in their natural habitat).
Instead of making a fortune, Bill’s fund was actually down over 2% during this period. The reason? Bill shorted german bunds but had also sold a bunch of straddles trying to juice the trade. What should have been a monster money maker turned into a loser.
The German bund market volatility during that sell off might seem excessive, but bond markets will increasingly trade in this manner. The longer you attempt to control a price, the greater the eventual dislocation will be. And Central Banks have been trying to fix prices for a long time now.
Out of all the markets where you could be short vol, developed market fixed income volatility would be last on my list. Almost no one agrees with me, which is why it is so worrying…
The MacroTourist “Secret Suit” top
A couple of my buddies emailed to rib me that my recent post about giving up trying to pick the top in the stock market was a sure sign the top was in. And I can’t say I disagree with them. Ever since writing that post the stock market has traded like dog vomit.
And just to show I can take it as well I dish it out, I am officially calling this the MacroTourist “Secret Suit” top until proven otherwise.
My only push back is that many traders emailed me all sorts of reasons why stocks were about to go down. And I have to tell you, I agree with all them. But shouldn’t a top look the opposite? Shouldn’t everyone be emailing me reasons why stocks have to rise, not fall? Something to think about…
Thanks for reading and have a great weekend,