I am a big huge Kodiak grizzly of a bond bear. It’s probably my number one conviction call. I believe, over time, long rates throughout the world will go higher – a lot of higher.
Yet the trader in me questions the wisdom of waking up this morning and grabbing a stack of pink tickets to smash bids in US bonds.
Let’s look at the headlines hitting the tape this morning.
Let’s recap. We have two of the world’s most recognized bond managers making some really bearish comments about US fixed income. Do you think Gross and Gundlach still have some selling to do? Not a chance. If anything, they are leaning short duration (at least versus their benchmark) and talking their book.
And even more importantly, we have China stating they may halt their purchase of US bonds. Again, if China had selling to do, would they jawbone down the price of US treasuries ahead of their sales? Do you think they are that naive? I will take the other side of that trade.
Now you might argue China didn’t say they would sell US Treasuries, but merely stated they might slow down (or stop) future purchases. The withdrawal of a big buyer would definitely weigh heavily on prices. Yet I believe China does not make these sorts of statements without some ulterior motive.
Here is some colour from Bloomberg’s reporting:
Officials reviewing China’s foreign-exchange holdings have recommended slowing or halting purchases of U.S. Treasuries, according to people familiar with the matter.
China holds the world’s largest foreign-exchange reserves, at $3.1 trillion, and regularly assesses its strategy for investing them. It isn’t clear whether the recommendations of the officials have been adopted.
The market for U.S. government bonds is becoming less attractive relative to other assets, and trade tensions with the U.S. may provide a reason to slow or stop buying American debt, the thinking of these officials goes, according to the people, who asked not to be named as they’re not allowed to discuss the matter publicly. China’s State Administration of Foreign Exchange didn’t immediately reply to a fax seeking comment on the matter.
First of all, the China State Administration of Foreign Exchange didn’t respond to the fax? Maybe the toner was empty?
But on a more serious note, this move is a negotiating tactic. Make no mistake about it. For whatever reason, China is choosing this moment to lean hard against the US Treasury market. I don’t know if they are trying to show Trump who is boss ahead of trade talks, or if there is some other game theory tactic at work. Either way, be careful assuming this is some market shift China announced ahead of time out of the goodness of their hearts.
How to play it
The recent backing up of long term US rates will tighten financial conditions. Up until now, as the Federal Reserve has raised short rates, the flattening of the curve, along with tightening of credit spreads, has resulted in easier financial conditions. Well, that’s now changing.
Now that the bond market is selling off, the Federal Reserve’s tighter monetary policy might in fact tighten economic conditions. This change might mean that now, instead of having to try twice as hard to slow down the economy, the Federal Reserve might find itself in a different situation where they can lean slightly against the wind and err a tiny little bit more easy. This equates to a steeper yield curve.
Having investors like Gross and Gundlach get negative on bonds, combined with some bearish rhetoric from China, might kick off the next wave of bear curve steepening.
But be wary of just assuming this is the start of the next bond secular bear market. Rarely do big name managers get the call correct down the day. The fact that everyone is so bearish leads me to believe there is a huge snapping turtle lurking beneath the brush, ready to bite the hands off of the newly minted bond bears.
Playing the steepener is a much better risk reward. Don’t forget the monster short speculative position at the front end of the US yield curve.
And although I have written about how the specs were betting on a flatter curve, I am shamelessly stealing Jeff’s great chart that shows the extent of this positioning.
When this trade unwinds, there is going to be some serious steepening.
An interesting development
Sometimes when a market relationship breaks down, it offers clues that something bigger is afoot in the financial system.
I don’t have any deep insights into these next couple of charts, but I think they are interesting nonetheless.
Over the past couple of years, the US 10-year yield has traded almost tick for tick with the USDJPY rate.
But over the past few weeks, US 10-year yields have been rising, while the USDJPY rate has been selling off (stronger yen).
The breakdown in the relationship is even more pronounced in the 5-year part of the curve.
I realize the BoJ recently announced some tapering of their QE, but this spread widening has been occurring since last November, well before any BoJ change in policy.
Longer term, I am both bullish on the Yen and bearish on bonds, so both of these developments are welcome news. And for a while, I struggled with holding both of these views due to the strong inter-market relationship. Yet now that it has apparently broken, I am getting more nervous that the next move might be for it to revert back for a bit.
Putting it all together
Although it is tempting to jump aboard the Gundlach/Gross/China bond bear trade, given the extended sold off nature of US fixed income, there are better trades. Buying bear steepeners or even getting outright short other sovereign bond markets are better risk rewards. I am going to write about this more in coming days, but the Canadian 10-year bond is yielding 37 basis points less than the US, with the Canadian economy consistently outperforming the US. Or how about the German 10-yr bund at a 55 basis point yield? I would much rather be short both of these markets than chasing the latest “hot headline call” from the two bond kings. If you are a longer-term investor, then, by all means, take heed of these US fixed income bearish calls. I strongly believe they will prove correct. Yet for anyone with a little more of a trading bent, take a breath and ask yourself where the next surprise will come from. There will most likely be better points to get short in the coming days or weeks.