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Guest Post: Treasury Bears And Extinction Events
Submitted by JM
Treasury Bears and Extinction Events
The real meaning of a treasury bear market may not be a flight out of treasuries into another asset class. Rather it real import could be the lack of liquidity available anywhere for nearly any asset class.
History seldom repeats precisely, but it does rhyme as they say. And there are different types of bear markets: bear steepening and bear flattening. Despite the complications, history and imagination are our only guides.
Bear Market in Treasuries
First for some rough context, monthly yield curves for the 1977-1982 Bear market are shown against the yields curves of January 1977 and December 1986 (in red). What you see is a massive sell-off across the curve combined with flattening and inversion of the short end.
See the close up below for something more digestible. There was serious volatility, mostly at the wings. Yields on the 1Y exploded from 8.16% in June 1980 to 16.52% in September 1981. Yields on the 30Y moved from 9.17% in August 1979 to 14.68% in September 1981.
Takeaways
This section is premised on ample liquidity. It is all I’ve ever known in Treasuries, but it may not be appropriate.
- Roll-down wasn’t possible at the mid-curve, but it was possible to get roll-down on the front end. It was a high-risk play, because the volatility was amazing and would rip your face off. In just a couple of months, the whole curve could invert on you.
- You could make money shorting 20s30s, but I can’t imagine anybody doing that more than as a punt. I don’t know if traders then bought or sold things like a 10s20s30s butterfly.
- A major point is that you really had to stick your neck out to make money in Treasuries. The “old” adage now is nobody ever got fired for buying treasuries—although it isn’t quite true. Seems that there was likely an even older adage about treasuries and how awful they were.
Presumptions of Liquidity
Liquidity acts in a financial system like ample water, ambient temperature, and clean air act in an ecosystem. It makes trading strategies proliferate. Further, it makes meaningful intermediation possible, fostering the growth in high yield bonds and marketable loans. Yes, derivatives like vanilla stock options and others too.
A financial system without liquidity is like a tropical ecosystem dried into a desert. Without liquidity, it is an open question whether the arbitrage pricing revolution will outlast the antiquated mark-ups of reinsurers. Liquidity makes random processes stationary, which is crucial to make the probabilistic foundations of risk neutral pricing work. Is it intuitively possible to price (and even more buy and sell) credit and interest rate risk without some liquidity in the underlying? How can a bank generate carry when the curve is flat and there is no appreciable differential anywhere that has a minimum tolerance of liquidity?
I put together an impressionistic schema to convey my point about liquidity. It not only demonstrates instruments stop functioning, but even wholesale trading strategies have to be abandoned. Traders will not only have a limited palette of instruments; for survival, they will also have to simplify trading strategies to those that are proven across extremely wide environments. In financial markets, liquidity is what makes innovation possible. Innovation adds complexity and diversity to an ecosystem, but it doesn’t make the system robust. Even miniscule changes in environment cause life to revert back to sparsely populated rhythms.
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no. they talk about currency traders instead. is there a shortage of liquidity there as well?
ZIRP. There is a point of no return. It is like stepping into a bucket of cement. One can step out until the degree of curing is such that it overcomes one's strength, and one is forever stuck.
Stay in a ZIRP condition long enough, and there is no out.
The world has experienced rate falls from 18-21% down to low levels, and survived it (this is easy). It has survived rate jumps from 4% to 8%, or 6% to 12%. Those are difficult, but not impossible to overcome.
The world has never tried to adjust from a prolonged period of zero rates to higher rates. Unless such a rise were protracted over a period of years, say 25 pip rise per quarter for three years, it doesn't seem it could be done. For Japan, it probably cannot be done over any period, given its sovereign debt level and servicing demands. Passed the point of no return, Japan has only two future choices: default or print. The US may have passed already the point of no return.
ZIRP takes away the incentive to cut government spending, as the incremental increases in servicing requirements are manageable. A rate rise when Timmy has shortened the duration of the UST issuance presents huge problems. Equally as problematic is what a rate rise would do for banks, whose new loans and refinancing of existing loans is wedding them to low nominal returns on the asset side of their balance sheets (long term assets) when the funding for these assets is almost all short term. EVERYBODY cannot hedge or match book at the same time if rates rise. To think they can is like thinking 1987's Portfolio Insurance was actually a viable strategy.
A different but related problem is the capital loss that comes with a rate rise when bonds are priced at a near zero yield. Do a quick calc on a hypothetical 10-year with a 3% coupon that suffers a rate rise from 1.9% to 3%. Ugly. Another problem is corporate pension funding. "All that cash" is not so great if corporations need to fill in for the underfunding.
Ben has kept the party going too long. Ask any bank funding desk how they will adjust when rates rise, and they give you an uncomfortable look. They KNOW it cannot be done. Most hope their tenure on the desk ends before ZIRP ends. If not, then the two---ZIRP and their careers---will end simultaneously.
I know there are funding desk people who read Zerohedge. Tell us how you are going to do it, or share with us your fears.
Thanks in advance.
Very astute observations. I don't work at a funding desk. But I do know what happened in 1994. And that memory sent a chill in late 2010 when the long bond yield spiked. Fed squashed that like a bug and what you described is why
i would rate this as "classic overthink" myself. this is precisely what the "monetary theologists" want us to program into our mind...."the illusion of their control." the fact of the matter is you need to take a step back and ask "what's going on inside Bernanke's head." It's not complitcated as "this is government." Simply put he is...as with all of us..."a solutions provider." All he does is walk in and say "you could do this" or "you could do that." The problem all TOO easy to focus in on: the Federal Government cannot have interest rates soar with trillion dollar deficits. "BUT WHAT ABOUT THIS" AND "WHAT ABOUT THAT!" you ask. And so we all do...here. That's called the "law of unintended consquences" as the implications of what Chairman Bernanke does has not been thought through at all...especially by Chairman Bernanke. "That's for the higher ups" as they say. And so..."we QE"...and so "we Twist"...and so "we ZIRP." Each represtents an alternative to only ONE thing: the null hypothesis...namely "of doing nothing." Since we have done something there's really no way of testing a "do nothing" approach and coming up with a "solved/not solved" analysis thus creating an alternative to the existing program(s). Having said that "this is finance" and not "some petri dish." The money truly is "flying about the world" and therefore if the theory(s) were total crap you'd know it immediately. We all know this because Europe took a "do nothing approach" and obviously "they're trying to be everything Ben Bernanke is without saying it." In other words..."not as good." That's why I say "avoid Europe" in an investing sense...for now. That is the realm of currency traders, sovereigns and our very own Bruce right here.
What a good post, Chindit.
Default or print is right. They'll print, I think.
This is why I want to look at the future implications of a bear market in treasuries. The only way to do this for me is look to the past, to conditions that has been seen before but outside of my personal experience. I need to hear from traders that saw this stuff and made something of it.
None of the tools in the trading strategy toolbox, even basic ones like roll-down, seem to work.
If treasuries are such poison, imagine how bad it will be everywhere else.
Thanks, JM.
To add to my post, banks face two disincentives to lend, and this seems to escape Bernanke. The first is obvious: an already poor asset quality discourages them from taking on any additional credit risk.
The second is an aversion to funding risk, that is, they are hesitant to add more low yielding assets when they will be scrambling to fund them when rates inevitably rise.
Combined, these two factors (credit risk and funding risk) paralyze an economy based on private debt accumulation, leaving the only source of new debt sovereigns (who can hardly afford it and who are terribly inefficient).
chindit, I really appreciate your posts.
As an amateur, I miss some of the technical issues at ZH.
Now, what to do?
Long US equities, short the 30 yr?
Get out of cash? Buy a house now and let hyper-inflation work for me?
Continue to buy bullets and guns?
Thanks again.
Buy a house now and let hyper-inflation work for me?
Inflation or hyperinflation isn't going to impact the price of a house (as a measure against the inflation)...
In a dumbed down sense, inflation (assuming there's no accompanying 'wage inflation'), is DEFLATION of paper assets [for which one may include the price of a home])...
It's the PAPER that's inflating (vs. the PHYSICAL)...
In even simpler terms... Buy what you 'need' (to survive), because the paper will become worthless...
Arguably, a house is a 'need'... But the problem is that the market isn't reflecting the depressed valuations yet (in most cases)... At this point in the game, unless you're lucky, you're still likely to overpay)...
Sorry for the 'hack-job' explanation...
Thanks for the insights, FS. Helpful.
I have indeed assumed wage inflation since the firm in which I work can easily adjust fees as rates go up.
Not sure that I going to be able to detect a bottom in real estate prices in our market, which is relatively good compared to CA, FL, AZ, etc.
Thanks for the insights, FS. Helpful.
I have indeed assumed wage inflation since the firm in which I work can easily adjust fees as rates go up.
Not sure that I going to be able to detect a bottom in real estate prices in our market, which is relatively good compared to CA, FL, AZ, etc.
Great Post Chindit.
The author here fails to consider what is the most important factor regarding liquity- quality. It is not liquidity that is the lifeblood of the financial environment, but investment capital free from debt.
Traders now play the robber, attempting to steal fractions from other traders. It is the quantity of liquidity that is at the very center of the problem. Why produce goods and services for profit, when you can steal the liquidity of others? Especially if there is a huge faucet spewing greater and greater amounts of liquidity into bathtub. Overflowing? Adjust the drain, but never turn off the faucet.
The tub is dumping water all over the floor and it's running downstairs. Call me when the house collapses, because the water will be running until it does and based on the original construction, the time could be long or short.
I appreciate your comment, though I repsectfully disagree about the most important factor.
In my view, the most important factor is a steep yeild curve. This means there is always money in sell short lend long. It makes repo work. It makes the whole system work.
Without a steep yield curve, you have to match maturities--take credit risk on spreads as opposed to term risk on the curve. Leverage is constrained even if there is big loan demand.
This is not just about bonds. Funding markets won't work as well, and loans based on LIBOR +spread become mondo expensive,
I could be wrong, but it is easy to see this as somehting akin to the Permian exptinction where 95%+ of all species became extinct. Except here I'm talking about trading strategies... and the people who use them.
Which gets back to Chindit's point I think. We have created a ZIRP environment and it has affected all classes of investments. We are playing with money that has no real discernable value. How do value your gains?
The whole system is polluted and like any polluted stream, it will provide plenty of water, but do you really want to use it?
One could argue that it is worse than the Permian extinction- it could go on forever, slowly degenerating and killing off all life except exceptional islands of priviledge and influence where the players take on mutated visages of our original human likeness.
The steep yield curve is a short term trading view and for you it works. For a long term producer interested in encouraging a viable economic system- not so much.
A steep yield curve is a part of the 25 year bull market in treasuries, it's not a short-term blip.
As far as producing and such: it gets measured by compensation, not subjective opinions of utility.
Steve Jobs has captured the imagination as a self-made man that made some innovative thing. People love that story and they don't love the story of bankers. But that doesn't edit out that they supported and enabled it at some point.
No offense meant in any of this. I book P&L in USD because that is how I pay my bills and stuff. If that changes I'll change.
But the way you're trading it is.
No offense taken nor was I implying any.
I don't love the story of bankers because fractional reserve banking is parasitic. Bankers serve a purpose, but when given control of currency they cease to benefit society and the economy at large. Thus, all modern bankers, by definition, could cease to exist and we would be better off for it.
They could then be replaced with a fee based banker.
You pay your bills off volatility. I get that, but it not how I pay my bills.
No where did Chindit's first post say that so I am not sure where you are getting that.
A steep yield curve is a must for investors. Why would I hold long dated paper if I can have a similar yield on the short end?
Chindit didn't say it, but then, I wasn't talking to Chindit. Try to keep up.
If that were true, no one would buy bonds without it. How do you explain hedge fund investment in sovereign debt?
Wut.
"Ben has kept the party going too long." Absolutely.
ZIRP, accompanied by periodic QE, TWIST, and TWAT operations, can't end or all Hell breaks loose. The FED no longer even hints at the possibility of an "exit strategy". Nobody dares talk about it any more. Doing so would crash asset prices. We'd have Cramer types flailing their forearms around on TV again.
Central Banks' actions have destroyed the markets' price-discovery abilities. By endlessly pumping "liquidity" into the system to prevent "fire sale liquidation" of over-priced assets, they've created a permanent artificial market for over-priced assets. Fundamentals and macro economics are trumped by "Don't fight the FED" and "The FED's got your back".
In one corner, wearing white trunks, we have mainstream belief that this is simply an economic rough patch, more stubborn than most but one we will overcome through government interventions. In the other corner, wearing black trunks, we have Zero Hedge lunatic fringe belief that something bigger is happening. That the entire system is breaking down, and government intervention is simply postponing an inevitable painful crash and reset.
"My prediction for the fight? PAIN!" (Clubber Lang).
I'm going to catch junks for this, but if you trade, which you should do in times such as these, Fed purchases and ECB buying that aims to make government securities default-free is an important fundamental you have to consider.
No reason to catch junk for that. You are absolutely correct. You might appreciate Rickards, "Currency Wars".
Rickards is smart and pompous. He chastised Zero Hedge for coming out and guessing QE was going to coninue, it did through OT2 and continued POMO ops, but he didn't think this was QE because Bernanke didn't use the term QE. Then he guesses the Fed would target inflation, they do, and he looks brilliant. The dude can't lose.
But he is smart and I am sure his book is good.
Well, if you had read his book, you would understand how it fits in with JM's comments.
Central Bank interventions (and rumors about same) are perhaps the most important factor to consider when trading today. They didn't used to be, but they are now. If you rely on the old trading systems (chartist, momentum stock, etc. etc.) you can get instantly creamed by some totally unreliable bullshit comment made by a stooge in the Eurozone or China or somewhere who "leaks" the Central Bank's next move.
I don't trade any more. I got eaten alive. I used to do Sector Rotation timing pretty well, but my methods no longer work. It's OK - I don't gamble with my eatin' money so I'm still comfortably solvent. I lost a lot of $ on what I thought were very good picks, though.
We are there where the Ottomans were, totally tied hand and foot to the decisions of the Sublime Gate; which gate is so mired in bureaucracy and day to day harem conspiracy, it could't tell a juicy onion from a hard cucumber. Everybody bows to the man with Romanov bearded jowls and no jewels of his own, the chief eunuch in charge of pearly gates of Imperial daily currency, duly provided by the belly twiching, gyrating witches who make the Sultan hungry, alike today's paid banksta shills, pushing him to say "Risk on, we attack Iran. Get my fleet and Seals ready, or, Risk off, I want a debt printing orgy right here and now; don't call me until I call you!"...In today's world the MIC and WS shills, sirens of big stick and bubbly money line tactics that make all meek men want to run to Shangrila, somewhere where Sultan has no hold in iron, debt obsessed, insatiably fast n furious fist.
Ben and BArry are there. And all the traders are crossed eyed watching which way the world they control goes : risk on, risk off. Either way the man who Zirps and the Potus who burps make all the plays as they have exorbitant privilege, like Ottoman vision from palace of intercontinental world divide. "Like a colossus we tower the world, and, we have no intention of paying you back, in a month of Athenian moans. Or Hapsburgian schize words." Now we have been warned...what goes up will never come around according to Sultan and head Eunuch of sublime town.
Chindit, I'm not going to claim I have as much knowledge about the bond market than you do but hear me out.
The FED only sets short term rates through FOMC that directly affect FFR, LIBOR and PRIME. Before setting any rate, it looks to the Open Market for guidance and therefore it actually lags the bond market by 6-12 months.
If we can agree so far, then lets move on.
Since the global and extremely liquid UST market is so immense, who really dictates yield? I would venture to say the Open Market does and what it's telling me is that low end ZIRP is all it can tolerate in this economy. Additionally, the yield curve does not exist in a vacuum but has pressure from all sides plotting it's curvature. We are burning off past excesses through defaults and bankruptcies which results in net MONETARY deflation and the curve is signaling further defaults, uncertainty and bad times ahead. Liquidity injections to stave off further deflation and asset depreciation is either trapped or there is little demand for it and it is this that affects yield more than the CB's.
So your assertion that the market cannot tolerate a whip souring of yield back to historical rates transposes cause and effect. The yield is the effect not the cause but it's the effect of open market confidence projected into the future by the magnitude of it's maturity duration.
''...what is labor.'' Lol. Ain't that the foundation for the chicken of the sea? Lol.
How hard (was) is it to see a ''title wave'' Lol ...of median income (42+-K) morons in 666K(now ZIRP down) homes in say ...Cali? ...combine with Larry Summers heat? Lol, ...not hard at all, if you lived on the beach(proverbial or not) and watched the tide go out. Tsunami Suprise my tuckus. You had to be stupid bull market blind, or just plain dumb and ignorant, to go after an out going tide, that road like Chairsatan on a Chinook in Indo China, muchless remain sitting on the beach. How in the hell is it so hard to see something so basic as illiquidity, when the income level spread is suddenly out beyond any normal tide? Charlie don't surf, and Tiny Turbo Tim does? LMAO. Crime wave, ...hell ...low, yer underwater and yer all dried up. Lol. A child could trade this corrupt market, if they are Lord Loyd of The Freaking Flies. http://www.youtube.com/watch?v=JSAEownqddg
The Fixx - Red Skies
C3X performance http://capital3x.com/trades/january-2012-performance-sheet-from-capital3...
http://www.youtube.com/watch?feature=player_detailpage&v=PwMVu5jT-BY
It's sad when the people you love the can't see the writing on the wall. They think they are stock pickers because they purchased at a fortunate time.
Yes, we all know the smart ass sponges that were told to dollar cost average. The people that have had nothing, and will never have anything. Your parents might fit the bill.
Thank God for floor safes. The pillaging won't begin in my home!
Sooo... is it really so stupid to be long TBT?
non sequitor, but Glenn (Beck) advertising himself as Nostrodomus is just too funny.
almost as funny as when Cramer was advertising on 0H.
The correct and technical name for U.S. "Treasuries" or USTs is U.S. Toiletries.
The only thing remotely "treasury" about USTs is that when they are worthless (as they are now but the sheeples worldover just haven't realized it yet) is that one can use them as fancy color toiletpaper.
Huh...The Fed does not own every T-bill...Others own them as well (China, Japan, S. Arabia, hedge funds, Underwater TBTF's, fake psuedo Cayman Bahama banks, my grandmother...My son's godmother owns them!)...
But...As the Fed becomes more of 'The buyer of last resort'...This percentage will increase over time...What does this mean? It means that no one else wants to commit capital (ie...loan the US Gov. money) when the risk/reward gets so skewed...
Sure...Loaning money to Greece at 4% seemed OK...Until it was obvious to all that it wasn't!! What's the point of loaning the US Gov. money if it might be frozen due to some political issue? That's the way it works...It will end at some inflection point in the finite future...Most likely sooner than later...
It also means that the Fed will do whatever it takes, no matter what to keep the bond bubble from blowing up! At this point, the free market completely separates...Which means whatever the US can't get at gunpoint...will be totally freakin' expensive/unavailable...The Fed/Banks will probably start loaning money to people that don't even exist just to keep the balls in the air (fake credit cards-transfer payments)...Just to keep aggregate demand and T-bill purchases moving forward...We don't know what lengths they'll go to...Ask the 10 foot tall 'Honey Badger Fed'!!
But ... but ... unemployment is down. The economy is fine. Do your public duty and vote for Obummer or the Romniator.
That's how "they" will do it.
They not only will print ... they are in fact printing now.
This isn't an illusion of control, it is control.
It's time to break the bank.
I'm long pitchforks.
LOL.. bring a pitchfork to a gunfight. I'm long bullets.
Tyler, you produce such lovely charts and graphics which just shows the computing power available today in the Intel i7 World compared to the 8086 world of the 1980s or the slide-rule world of the 1920s. It does make you wonder however if Bankers became ever so stupid when they employed PhDs in Mathematical Physics to develop computer simulations for such "Events" as LTCM and the whole idea of trading synthetic bonds with no real ownership of underlying components.......whether the plethora of computers made those running banks treat everything as a "black box" and fail to understand that Mathematics is NOT reality but only a man-made approximation
Everything is an approximation. Reality is just another model.
OT/
But energy is such a hot topic; so get your daily soaked in oil bread from BP :
BP Thinks America Is Just Years Away From Energy Self-Sufficiency The Oil Drum | 13 minutes ago
Read more: http://www.theoildrum.com/node/8897?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+theoildrum+%28The+Oil+Drum%29&utm_content=Google+Reader#ixzz1lQFbiovn
2030?
I see they've factored in the complete success of an overtaking of Azadegan as if it were somehow in doubt.
You do fine comedy my friend.
God I hate hearing about innovation in the financial markets! It is the core of the problem...fractional reserve lending = excess "liquidity" = financial innovation = what a wonderful li(f)e. Volker said it best...the most innovative thing to come out of the financial industry in the last 30 years is the ATM.
Hum why doesnt Johny Bravo relog in with his ancient pseudo ? Did he forget his login details when his short gold got margin called ?
Liquidity is a loan. Interest rate is a reflection of risk, risk of many elements, not-the-least-of-which is the forecast of future interest rates themselves.
Won't the really interesting consequences then come with the endgame? The longer this drags out the more longterm "liquidity" that is locked in at artificially low rates. Once rates rise, if they are ever allowed to, the tables will turn. Liquidity will abound but rates will rise.
Like George Bailey explained to us, money isn't kept in banks, it's lent out. Banks then pay for operations with the 'interest'.
What happens then when the cost to borrow money is more expensive than what it is lent it out at?
Look at housing. A $100k home is refi'd at 4%, the annual interest paid is roughly $4k along with a nominal balance payment of say $2k. Fast forward. Rates are now back up to 7% and the homeowner sells for that $100k. The buyer puts down 20% and the lender puts down the rest. That $80k is liquidity. If it costs 4% to borrow that money while a majority of the homes in the portfolio are still at 4%, how do you say in business for that period of time until enough 7% houses are added to the portfolio?
One quick aside, not directed at your main point: liquidity in my view is a tight bid-ask... you know that value of what you have. You seem to say that liquidity is leverage. This seemingly minor point is prolly worth a deeper discussion than it normally gets.
To your main point, if I understand it. The endgame is ambiguous. Sure, a bank has assets and capital provision that are both eroded given high inflation. But if said assets are linked to a floating rate, then a bank can gain from high inflation. Also if a credit can continue servicing for a few years through the inflation it makes asset performance better in the long run, and a bank is willing to deal with this kind of haircut as a matter of business. This problem is that if inflation is very high and credit quality is low, then credits can't continue service. And you have a subprime meltdown. There is a complicated interaction between inflation, credit quality, and leveraging.
That said, I can't conceive that an inverted treasury curve speels anythign but pain beyond my experience.
For those of you who haven't received your Ovaltine decoder ring in the post.
If find it fascinating that this "legend" of ZH ( "Can Hamz Bitchez" or "Johnny Bravo") thinks he knows everything about anything. Go right ahead sir and buy all the canned hamz you want, but wtf do you think us gold and silver bitchez have been doing other than buying pm's? that's right, buying spam, tuna, beef jerky, rice, flour, sugar, SALT; especially salt, anything in a can and that includes canned hamz. You think all we do is sit on and look at our silver/gold and that's all we think about. It's arrogant thinking that gave us this POS of a president. Besides, if joos run the world what makes you think they are going to want any part of your hamz? Or did you forget that little thing about joos and pork. All that ham will be good for is deterring Muslims which if you think about it Islam is a religion that begins with I and ends in slam. Before you get all high and mighty with yourself you may want to remember that you to will have to live in this country when it emplodes and if OWS taught you anything is that the people are tired of greedy extorting mofo's like you and they will enact their revenge upon those that behave in such a manner. Try getting a bj for some canned hamz. If you do you better use it for whoever has the most penicilln to clear that up.