This page has been archived and commenting is disabled.

The Worst Risk/Reward Trade on Wall Street

EconMatters's picture




 

By EconMatters  

 

The Rigging

 

So a bunch of folks in Hedge Fund Land have this idea that they can force a bit of a squeeze in the bond markets, and all the sudden the boring old bond market has been on the media roadshow by firms trying to talk their book, and get others to follow suit, and go long the bond market. 

 

It has gotten so bad that these same “investors” have started piling into the futures market with some short-sighted notion that they can affect bond prices by driving the futures prices. If we look at the 10 Year Yield it has stayed constant between 2.58-2.62 for the most part since the employment report. However, the futures market for the same 10-Year has all the sudden jumped from the normal correlation earlier in the week to the bond yield to aggressively ahead of the 10 year yield.

 

Furthermore, the price action of this 10 year futures contract all the sudden started acting very strangely whereas the 10-year actual bond yield would move but the futures contract would barely budge. This for experienced traders says somebody is propping up the contract, and refuses to let the contract fall regardless of what happens in the bond market within possible reason. It all the sudden is a one sided market with somebody protecting their position until they are forced out of the trade.

 

Worst Risk/Reward Trade on Wall Street

 

There are a lot of bad trades on Wall Street, there are a lot of not-so-smart people managing money, it really is all about sales in this industry, i.e., AUM (assets under management). But the goal of this trade is to take the 10-year yield down to the 2.49 level give or take a few basis points. So let’s get this straight, these people are trying to make 10 to 12 basis points on a trade while risking 75 to 150 basis points conservatively in the next 6 months. 

 

Furthermore, they have proposed this trade when the Federal Reserve is actually getting out of the business of buying bonds, and we just had a 300k jobs report which we have been waiting 6 years to finally realize. Great timing geniuses, of all times to be short yield, this is about the worst time in history to be shorting yield from a risk reward standpoint. What do you think is going to happen to inflation numbers once these minimum wage plans get enacted in raising these wages across the board in the economy – inflation spike in terms of massive pass through by Corporations. What do you think is going to happen in three weeks on the next employment report when the trend in the jobless rate declining and another 250k plus hits the wire? The job market finally starts kicking and you want to short Treasury yields, that isn`t a good long-term strategy for maintaining those AUM as Thursday`s Bond Auction reinforced that nobody wanted those 30-year Treasuries with this low of a yield – that is a sucker`s bet!

 

Where do you think Treasury Yields are going to be by year end with no Fed buying whatsoever? You think a 2.60 yield is going to inspire investors other than our government to buy these treasuries given the inflation risk that ultimately hits after the job market becomes tight, wages increase pushing cost through to compete for workers, and boom all the sudden the PPI & CPI inflation gauges spike to 3%, and everybody rushes to get long yield as an inflation hedge.

 

I could continue to elaborate on why this is such a bad trade, and the geniuses can load up all they want on 10-year futures contracts, but this isn`t the oil market – a largely paper market these days. Somebody actually has to be willing to buy a Treasury with a 2.5% yield on a Ten Year timeframe, and risk losing boatloads of principal in the process.

 

Ukraine &Russia

 

This has become one of the most overhyped Geo-Political Event in recent memory. The US isn`t going to war with Russia over Ukraine, Obama made the mistake of even being involved – this is Ukraine for crying out loud. One of the most corrupt countries in the world, and base camp for hackers around the world.  

 

The US should let Russia do whatever they want in Ukraine. There is an old adage if a competitor is trying their best to sabotage themselves, don`t stand in their way. Russia will look back very unfavorably at any morass they get into with Ukraine – another Afghanistan headache for them. 

 

The Russia-Ukraine event is a red hearing, and overhyped by news media looking to bolster ratings in a pretty boring world news wise. It doesn`t matter one bit if Russia invades Ukraine – great for them they now have a bastion of internet hackers with all their associated international baggage to try and manage – good luck with that one.

 

Risk & Reward

 

In conclusion this trade is one of the worst setups I have come across lately, and I cannot believe this many so-called money managers are pushing this at investor conferences. Analysts who know nothing about bonds are now on CNBC talking about yields on the 10-Year with nonsensical technical analysis jargon that forgets the main point – all previous prices were artificially affected by a Fed that is getting out of the market – Hello! The incompetence on Wall Street just never ceases to amaze me; there are some not-so-bright people in this industry. Yeah maybe there is a case when the employment reports were coming in around 90k, but certainly when we are upwards of 200k and trending higher on the employment report, this has got to be one of the worst possible times from a risk/reward standpoint to be shorting yields!

 

© EconMatters All Rights Reserved | Facebook | Twitter | Post Alert | Kindle

 

- advertisements -

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Fri, 05/09/2014 - 13:33 | 4744039 madbraz
madbraz's picture

The author has got it all wrong - what a poor article.

 

Absent QE, yields crater lower.  There is not enough collateral (treasuries) to support the crazy leverage on bets on risk assets.  

 

Now the FED is using reverse repos to provide collateral to primary dealers (and indirectly to hedge funds) and a good chunk of it is used to short treasuries.  

 

Anyone who looks at markets can see that yields now "misteriously" spike only at 5AM to 9AM and 11AM to 1:30PM.  That is primary dealer time - in the futures market and when they get $20 billion in collateral at 11AM (NY FED securities lending) and $200 billion in collateral at 1:00PM (reverse repo).

 

During the course of "regular trading", when big institutional trading is taking place (read fixed income mutual funds, pension funds, foreign governments and insurance companies) there is a constant bid that guides yields lower.  

 

I mean, in a world with sub 2% growth, a treasury that pays 3.4% per year for 30 years while the market pays a dividend of less than 2% and Spain pays less than 3% for 10 years is always going to be met with institutional demand.

 

 

Fri, 05/09/2014 - 14:48 | 4744343 aliston
aliston's picture

This is the first I've heard someone claim that QE (adding liquidity) pushes up interest rates.

Also, aren't reverse repos essentially a short-term reversal of QE?  It makes sense that interest rates would spike when the FED is removing liquidity, and is an argument that QE is artificially lowering interest rates.

Fri, 05/09/2014 - 11:41 | 4743561 RMolineaux
RMolineaux's picture

I agree with the author when he says that there are a lot of intellectual light weights being drawn to the sugar of 2 and 20.  He could also use an editor as his english leaves a lot to be desired.  But that is par for the Wall Street gang.  On the substance, it appears that he has bought the currently-fashionable story on the economy.  He talks about 300K plus new hires and 100K minus new claims for unemployment.  That appears to be making a lot out of one month's and one week's performance.  What's more, many have pointed out that most of these new jobs are close to the minimum wage, leaving that earner still eligible for food stamps.  Add in the shambles in which our banking system finds itself, with lack of trust between banks and an overhang of fragile derivatives, and I find little cause for the optimism expressed.

Fri, 05/09/2014 - 11:11 | 4743415 Yancey Ward
Yancey Ward's picture

There is just one problem with this thesis- ever since 2008, bond yields have fallen when the end of a QE was reached.  Now this has, in my opinion, been in anticipation of the next QE, but there is also, now, the fact that the federal deficit is rapidly contracting.

Look, I don't know where bonds are going, but I look at that long term yield trend since 1981-still unbroken!- and I look at the Japanese experience, and I still think you haven't seen the lows on the treasury yields.

Fri, 05/09/2014 - 11:33 | 4743521 Redneck Hippy
Redneck Hippy's picture

QE continues.  Though the Fed is pulling back, its balance sheet is still expanding.  Same is true in Japan, on steroids. ECB is engaged in QE surreptitiously, hence the low periphery yields.  China has outright fiscal stimulus, although they keep saying they will stop, they won't.  All stimulus is fungible, this being a global economy, hence money washes up in the lowest risk environment, the U.S. bond market.

 The gap in yields in Japan vs. U.S. is ridiculous, as there is no way the Japanese debt can be repaid. Everybody knows this, but everybody ignores it.

The bond market rally continues until it doesn't.

Do NOT follow this link or you will be banned from the site!