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The Growth Trade Vs. The Bond Calendar
Over the past few months market psychology has gone from enthusiasm to
dismay in the course of a fortnight. Back on June 12 the talk was,"China’s
roaring back, load up on copper!”. “The 10 year’s at 4%, it’s going to
5!” “There will never be a down week in the market for the rest of the
year!” Just four weeks later, on July 8th, the talk was, “Oils going to 20, the commodities trade is dead!”
As
of last Friday the overall market sentiment was back on the ‘Growth
Trade’. The ‘investors’ on TV were talking about their longs and a big
shot, Warren Buffett, said, “Short bonds, buy stocks”. Even Alan
Abelson at Barron’s had something positive to say in his weekend piece,
“It Could Be Worse”.
There
are a lot of ways to make a bet on the growth trade. One could; move
equity money away from health care and back to growth, play commodities
long, position for a steepening of the curve, short bonds outright, get
leveraged long in equities, get short the Yen and long the Aussie. The
list goes on and on. The following chart tracks oil, S%P and the
10-year note yield for the past three months. Directionally they match.
There is some divergence during the June 14- 29th period. There can be
little doubt looking at this, that from July 10-24th the markets have
been directionally converging on the growth trade.
A
market sentiment that is biased to growth is a lousy market to sell
bonds into. Treasury has a bundle on offer in August. The auctions next
week come to a very lumpy $240 billion. $120b. in short date, $120b in
coupons and TIPs. The balance of August has tons of additional fixed
rate paper coming. Prior year increases in Treasury IOUs for the month
of August were: 2006=$68b, 2007=$100b, 2008=$79b. Based on the
following schedule from Treasury, the August 09 total issuance could
exceed $400b. Keep in mind this is August, a month when a lot of bond
folks are out at the Hamptons.
It
is not an easy task for the dealers to position for this supply. At
their level the cost of being short the ten-year overnight is = (3.6%
-. 25%) / 365. Based on that, you’re average $500mm overnight short
position will cost you $50,000 in carry. The street has learned the
hard way that being short bonds can be a very costly trade. The drop in
yields for the ten-year from 3.98% to 3.32% was a doozy. It cost the
shorts a bundle. The result has been a spike in volatility. That
increase just adds to the hedging costs.
The
convergence of the August calendar, the current market psychology and
the high cost of shorting sets up the possibility that the upcoming
auctions will put significant upward pressure on bond yields. We may be
headed back to the 4% level that was touched on July 8th. Should that
happen, the talk will revert to, “Mortgages are pushing 6%. Housing is dead! The financials will get killed!”
The
last month of summer is setting up to be an important one. Possibly by
the end of August we will have learned something. If the economy is in
recovery mode the ability to finance the $2T deficit issue has to
resurface. The question will become, “Can we fund the deficit at a price we can afford?” In my opinion this question is going to be answered before the end of September. That answer will be, “No, at these costs the deficit will overwhelm us. The growth trade is dead!”
This market sets up well for people who can go both ways. For the buy and hold crowd, look out, you’re going to get hurt.
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I think you buy 4% 10's. The market seems to be carving out a range trade between about 3.30 and 4%. I don't see yields able to get much thru 4% with the economy being as weak as it is, but also bounded on the lower end by enormous supply. Just one man's opinion...
Aon: 'yeat' was properly used, but should have been capitalized. It stands for Year Equivalent Adjusted Treasury...
As for Mr. Buffett, that is a problem with spell check. This guy has been around long enough to have his name in your standard software. My apology to Waren.
Hi Bruce,
* 10 yeat bond market
* Warren Bufett
Two tag typos :(
The table of Treasury auctions is mostly May June and July. I don't see ho whe says there is $400B of new August auctions from this data.
Anybody able to point me to a source for what the August requirement will be?
Great post.
I see a lot of the inflation vs deflation semantic debates. And the economy vs financial markets.
Its much better to have a flexible mindset while taking advantage of markets while long or short.
Mr. Krasting does an excellent job of pointing out how the bond market moves in tandem with with the equities/growth markets which underscores how bonds are not necessarily a flight to safety - and probably nothing really is.
I don't want to put words in his mouth but he has done a good job of explaining in layman's terms the sobering reality revealing that we can't afford to finance the deficit any longer.
I'd like to hear his thoughts on Peter Schiff economics, reforming or abolishing the Fed and despite the extreme boring nature of gold/silver as a reserve currency whether or not his crystal ball indicate if/when that genie will come out of the bottle.
Hard money ain't ever coming back. Never ever. Since the supply of precious metals grows much more slowly than population does, on either a national or global scale, a hard money move is incredibly deflationary.
A new reserve currency makes more sense. Looking at the various factors (government transparency, social stability, natural resources), I think the Brazilian real makes the most sense.
* Renminbi: China is not transparent and fails the natural resources test.
* Rupee: India is borderline on transparency (Satyam anyone?), kind-of stable (Kashmir and Maoist insurgencies anyone?), but bombs the natural resource test. It can hardly feed itself.
* Ruble: Yeah, GTFO.
* Real: Does the best on all three, though a viewing of Ciudad de Deus might call the stability into a bit of question.
Neither governments nor independent central banks are capable of responsibly managing a currency over a significant period of time. History proves that truth absolute. And to say that a gold standard is "incredibly deflationary" due to population growth rates exceeding gold supply growth rates reveals a critical misunderstanding of what a gold standard is.
A gold standard is NOT a monetary system in which transactions are settled in gold. It is a system in which a currency can always be exchanged for a fixed amount of gold.
Yes, but if you keep the ratio of currency units to amount of gold fixed, and the demand for money increases, how is that not deflationary? You either have to increase the money supply or accept a decline in standard of living.
And if you don't keep that exchange rate fixed, how is that better/different than a fiat currency controlled by central bank interest rates?
Anon,
You may want to rethink your statement about
bonds not being a flight to safety. The article is
refers to the ten year YIELD. Price and yield move
in opposite directions from one another. Just an FYI.
P. Prophet
"For the buy and hold crowd, look out, you’re going to get hurt."
that's why warren's been trying so desperately to jawbone this market. he's in trouble. on a long enough timeline etc. poor guy lived about nine years too long.