First it was Gross, then Gundlach. Now billionaire hedge fund manager Paul Singer of Elliott Management has unveiled what he believes is the trade of this generation: being short "long-term claims on paper money, i.e., bonds." He calls it the "bigger short." First hinted at during the Grant's Spring 2015 conference, he now goes into excruciating detail.
Select excerpts from Paul Singer's latest letter.
The Big Short, of course, refers to short positions in credit in the period 2005-2007, more specifically structured credit. To be even more precise, it refers to subprime residential mortgage securitizations. It is also the name of a best-selling book by Michael Lewis about the housing and credit bubble. It was called the Big Short because many forms of credit were so overpriced that the risk/reward of taking on short positions before the financial crisis was extraordinarily favorable.
Today, six and a half years after the collapse of Lehman, there is a Bigger Short cooking. That Bigger Short is long-term claims on paper money, i.e., bonds.
History shows that it is fiendishly difficult to preserve the value of money which is backed by nothing but promises, because it is so tempting for rulers to debase their currency when they think it will help them repay their debts. The long-term preservation of the real value (i.e., the purchasing power) of fiat money and bonds is obviously of little or no importance to today’s creators of money – the major central banks – who currently can’t debase money fast enough for their tastes. Yet, the current prices of bonds are at all-time highs, and thus yields are at record lows, because the central banks are buying bonds with trillions of dollars of newly printed money, despite the facts that 1) the global financial emergency ended over six years ago and 2) the developed world has not suffered a renewed financial collapse or deep recession. The central bank actions are unprecedented under these conditions, and their policies are partially responsible for the sluggishness of the economic recovery in the developed world since the 2008 crash. Below we discuss why that is the case, and we set out a number of elements that lead us to the conclusion that the risk/reward profile of owning long-term high-quality bonds at today’s prices and yields is uniquely poor.
Our view is that central bankers have chosen, and doubled down on, a palliative (super-easy money and QE), which is unprecedented and extreme, and whose ultimate effects are unknowable. To be sure, the collapse in interest rates all along the curve, and a bull market in equities, “trophy real estate” and other assets, has had some effect on job creation. However, the effect is indirect, and in our opinion the benefits of complete reliance on monetary extremism are overwhelmed by the negatives and the risks. To begin with, such policies are inefficient in actually creating jobs and growth, and they worsen inequality: Investors prosper and the middle class struggles. The goal of leaders of developed nations and their central bankers should be more or less the same: enhanced growth and financial stability. But somehow the principal policy goal of both has become to generate more inflation. Both extreme deflation (credit collapse) and extreme inflation (which forces citizens to forego normal economic activities and become traders and speculators in a desperate attempt to keep up with the erosion of savings and value) are threats to societal stability, and we don’t actually think there is much to choose from between those extremes. But central bankers are completely focused on erasing any chance of deflation, and the tool to do so – currency debasement – is certainly near to hand. Therefore, the likelihood of deflation is highly remote. By contrast, the central bankers’ universal belief that inflation is easy to deal with if it accidentally overheats is arrogant and not supported by the historical record.
Furthermore, we fail to comprehend how owners of claims on money (that is, bondholders) can continue to ignore the fact that the goal of generating more inflation is aimed precisely at reducing the value of their capital. Central bankers obviously do not understand that the modern financial system is almost impossible to “manage,” and is fundamentally unsound as currently structured and leveraged. Given that reality, why should bondholders believe that central banks are capable of creating just enough inflation, and not a farthing more, in their current quest to rebubble-ize the world? We also question why bondholders believe that if inflation bursts its dictated boundaries despite central bank scolding, that policymakers can indeed, as a former Fed chairman and now immodest citizen blogger and incoming hedge fund advisor (Ben Bernanke) has said, cure it in “10 minutes.” We call to your attention the hand-wringing and agonizing now underway about raising U.S. policy rates by 25, 50 or 75 basis points over the next few months. Imagine the caterwauling in global financial markets if inflation surprises everyone on the upside and the right policy rate should be 2%, 4% or higher. Given the fragility of the financial system and its still-extreme leverage, even a few points of inflation and a few hundred basis points of increase in medium- and long-term interest rates could cause a renewed financial crisis.
Inflation is more or less a generalized diminution in the value of money. A bond is an instrument by which a promise to return, in the distant future, a fixed-in-currency amount of invested money is supplemented by periodic interest payments in the meantime. That’s it, and that’s all you get. Such interest payments are meant to compensate the investor for the use of his or her money, taxes (if any) and expected inflation. At currently prevailing interest rates in the developed world, if there is ANY inflation in the next 10 to 30 years, investors who buy or hold bonds at today’s prices and rates will have made a bad deal. And if inflation emerges from the stone-cold dead and walks, trots or (heaven forbid) gallops into the future, they will have made a very, very bad deal.
Equity values depend to an important degree on confidence that policymakers will continue to allow private enterprise, profits and private ownership of assets. But bonds, in our view, represent a greater leap of confidence. It is so much easier to purloin value from bondholders, and so tempting to rulers; in fact, the current leaders and policymakers have said in so many words that there is not enough debasement (that is, inflation) underway at present. You don’t need a weatherman to know which way the wind blows (according to Bob Dylan), but bondholders nevertheless continue to think, up to basically this moment, that it is perfectly safe to own 30-year German bonds at a yield of 0.6% per year, or a 20-year Japanese bond (issued by the most thoroughly long-term-insolvent of the major countries) at a little over 1% per year, or an American 30-year bond at scarcely above 2% per year.
Asset prices are skyrocketing because of massive public-sector purchases. The tinkering and experimentation that characterizes each round of novel central bank policy leads to more and more complicated unwanted consequences and convolutions. Central bankers are, in our view, getting “pretzeled” by all this flailing, yet they deliver it with aplomb and serene selfconfidence. Are they really taming volatility with their bond-buying, or just jamming it into a coiled spring?
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Sometimes inflection points take a while to actualize, even when they are long overdue. For example, the unsustainable dotcom stock boom went on and on in the late 1990s, with the American stock market PE passing its all-time historical high in 1995, before topping out in March 2000 at a level twice the previous 1929 and 1972 peaks. All it would take at the present time for a collapse in developed-country bond markets to begin is a loss of confidence in paper money, central bankers or political leadership. Any combination of these could occur due to the market’s fear or projection of future increased inflation, which could bring about or accompany a self-reinforcing cycle of securities depreciation and other asset price and or wage/cost appreciation. Or perhaps a bond market collapse could ensue as part of a currency crisis in which one or more of the major currencies suffer an unexpected precipitous decline. Up to now, bond markets have acted more like puppets on a string. It would be a large and unpleasant surprise, shaking a lot of assumptions, if bond markets softened as QE continues to build and expand globally.
Current conditions are extraordinary. There has been no global deleveraging since the GFC; in fact, worldwide debt has experienced a further massive increase in the last six years. Long-term entitlement programs have not been pared down to accommodate reality. Derivatives have not lessened in complexity and have actually grown in global size. Moreover, the financial statements of global financial institutions have not moved from opacity to transparency. The ingredients for a renewed financial crisis are in place, as is a possible “surprising” transformation of money debasement into highly-visible inflation.
A good or great trade is not created by just the prospect of a big move in a direction. The ability of investors to engage in a superior risk/reward profile, and to finesse the question of when the expected move will occur, is what separates “just-ok” trades from great trades. It is the extreme overpricing of bonds, and the universal confidence (unjustified, in our opinion) of investors in central banks and in the current mix of perceptions about what is safe and what is not, that makes the Bigger Short into possibly a great trade. To be sure, while a great trade is not a guarantee, at current prices the bond markets of Europe, the U.S., the U.K. and Japan present precious little future reward and a great deal of risk. No investor’s actuarial requirements or investment return goals can possibly be met by today’s long-term bond interest rates, but investors are holding them nonetheless because they have been making money on their bond holdings persistently and seemingly inexorably for the last few years. The day when their perceptions are challenged and they change their minds, only to find that the exit door has been blocked by everyone else doing an about-face at the same time, is going to be one heck of a day for those who have positions in bonds, whether long or short.
The Big Short was compelling pre-2007 because the pricing aberration in a specific type of debt was so huge that it didn’t cost much to wait for the trade to go right (the precise timing being impossible, as usual). We became interested in The Big Short when we saw data that subprime mortgages were defaulting at high rates even while house prices were rising. Today, the Bigger Short is in a much larger marketplace, so it can be undertaken in whatever size one can stomach, and the cost of effectuating it during the waiting period is really low. However, the power of the herd on the current upward bond price stampede is beyond anyone’s control, so one can lose money waiting for the trade to work out.
In terms of directional trades representing extremes of value, the Bigger Short is in a rare category. It is certainly not riskless, because nobody can predict how much staying power policymakers can have when they are unconstrained and have a theory (as unnerving as their theory is), and when citizens are passive and complicit in what we regard as central bankers’ risky policies. Of course, not every trader or investor is in a position to actually short bonds, but our reasoning is equally applicable to the decision of whether or not even to continue owning medium- and long-term bonds at today’s prices and yields.
This analysis is not just about one of the more interesting asymmetries of risk and reward in market history. Rather, it is about leaders abnegating their responsibilities to their citizens (in the case of presidents, prime ministers and legislators), and other policymakers (central bankers) engaging in risky, extreme and untried policies to the point where they are in way over their heads and violating (by design) the moral compact between governments and citizens that is the basis of paper money. Central bankers like to protect their “independence,” but that is absurd in the current context. In what sense are central bankers independent if their extreme policies just give cover to political leadership to do next to nothing to restore sustainable levels of growth? Central bank independence is a concept meant to protect the value of fiat money against grasping politicians, not to empower central bankers to pick winners and losers, allocate credit and behave as if they are fiscal authorities. Certainly the Fed’s “dual mandate” to pursue both monetary stability and maximum employment ought to be replaced with a single mandate to focus on financial and price stability. It doesn’t matter that the other major central banks are engaging in similar practices (QE and ZIRP or NIRP) despite lacking a maximum-employment mandate of their own; eliminating the dual mandate would still be an important symbolic act aimed at pushing back against the arrogance of the Fed and forcing the President and Congress to face up to their responsibilities for optimizing growth and sustainable employment.
The central bankers of the developed world are the architects and enablers of a policy mix whose most powerful result is to further enrich the already well-off, which is clearly posing a challenge to the social fabric of the developed world. It is possible that this situation could worsen if central bankers, frustrated by their economies’ refusal to dance to their incessant piping, step up the pace of their bond-buying and possibly convert it to more direct forms of money-printing, which at some point is certain to ignite the inflation that they have been trying merely to kindle. Don’t fall out of your seats if inflation then burns right through the finely-tuned “target” and keeps on going. If this happens, we all may find out whether they indeed can, or have the courage to, stop inflation in “10 minutes.
We, as usual, agree with most of what Singer has said, with one exception - the same exception we noted in "So You Want To Fight The Central Banks? Then Short Treasurys." Here is the key part:
As central banks have scrambled to push risk assets ever higher in hopes of creating that elusive Keynesian inflationary "trickle down", they are limited in the security they can buy. In fact, most can only purchase government treasurys, which they have done en masse. This is known as QE.
According to BofA calculations, central banks now own $22 trillion in "assets" - almost entirely in the form of government debt (an amount greater than the GDP of the US and Japan combined) - which they have to buy in order to create the balance sheet liability, reserves, which primary dealers and the world's commercial banking system use to bid up risky assets.
Furthermore, according to Citigroup, the amount of debt monetizations in 2015 will be the greatest in history: so great is the scramble to reflate that central banks around the globe (most recently the BOJ's expanded QE and the ECB's brand new Q€) that the money printing academics have now gone all in.
As the chart above shows, the global financial situation is so grotesque, central banks will monetize all net debt issuance around the entire world just to push everyone into the riskiest of assets: stocks.
If there is still any question why nobody believes the fallacy of a "recovery", the chart above should be sufficient to prove to anyone that there is no self-sustaining economy in the world anymore just one massive printing orgy and a doomed attempt to reflate $200 trillion in global debt at all costs.
But back to the topic of QE: as central banks rush to issue reserves, they have no choice but to buy government bonds. Some $22 trillion of them as we noted above. And what happens when epic, epic amounts of government debt are purchased by central banks (just yesterday the BOJ monetized about $10 billion in debt in its daily POMO - and this happens several time per week)? Well, as we have shown since 2012, the bond markets freeze up because central banks soak up all the liquidity, but more to the point, bond prices go up and yields go down.
And this is where traditional economists #Ref! out. Because what is the fundamental prerogative behind QE? It is not to push the S&P to 2100, 3100, or higher. It is to stimulate inflation. The problem however arises when central banks just can't get enough of government Treasurys and their yields, as witnessed recently, go negative. In fact it was just a month ago when we showed that 53% of all global government bonds are yielding 1% or less!
And the punchline: what are bond yields? Well, in a normal world, they telegraph the market's long-term inflation expectations. However, in this parallel banana universe in which everything is planned by a few clueless academics, all they "telegraph" is that central banks are the first, last and increasingly (hi Greece) only buyer of sovereign debt. The irony is that the higher stocks go, not because they should but because central banks push them higher, the lower yields slide as central banks buy more bonds to inject more reserves, to push stocks higher, to blow an ever greater asset bubble across all asset classes: both bonds and stocks.
Even more ironic is that not a day passes without one clueless pundit after another appearing on TV and reading from the teleprompter like a stoned zombie that one must not fight the Fed (and central banks) and buy stocks while shorting bonds. And yet what are central banks buying?
Not stocks (at least not officially in the case of the Fed; only the BOJ and the SNB admit to openly monetizing equities).
The answer: bonds.
In other words by simple bond math, the more central banks monetize, i.e. buy, bonds in hopes of pushing stocks, and inflation higher, the lower yields go. Along the way you get such monetary abortions as ZIRP, NIRP and so on, but the math is clear: central banks hope to push up risk assets by kicking everyone out of so-called riskless assets. Which is precisely why bonds have performed so well in the past several years: everyone has been frontrunning central banks!
And the more central banks push, the more bonds they have to monetize. Indeed, as shown in the chart above, in 2015 central banks will inject a record amount of liquidity into the global market, surpassing even the year of the Great Financial Crisis! All this liquidity pushes stocks higher... and drives yields lower.
At the same time, and here we fully agree with Singer, the global economy continues to deteriorate as ever more zero-cost, money equivalent debt is piled up, debt which will implode the second yield shoot higher and lead to a global domino-like default wave while the rich get richer courtesy of their risk asset holdings, pushing class inequality to record levels and beyond, and leading other legendary hedge fund managers such as Paul Tudor Jones to hint that it all will end in either war or revolution.
So what do central bankers do? They have no choice but push harder, and do more of the same, as in the BOJ and the ECB, both of which have either launched or boosted their bond monetization program in the past year. End result: more than half of all global bonds traded under 1% recently. Why? Because bond investors know central banks will be there to buy these bonds.
And hence the biggest paradox: the more deflation there is, the more QE there will be, the lower the yields, the more deflationary signals, the higher stocks go, and so on, in the most paradoxical circular argument in monetary history. Of course, for the Fed to stimulate inflation, it has to step away from monetization altogether, but that would mean an uncontrollable collapse in bond prices, an epic "taper tantrum" and a surge in yields (see Bunds as of a month ago), and worse, a collapse of faith in central planning.
Central banks can not have that, which would mean they would promptly re-engage once more and double down on their bond purchases restarting the cycle afresh. And so on, and so on.
Which brings us to the other definition of Singer's bigger short: that of "long-term claims on paper money" which this complete sense, because Singer's real short is not on bonds, but the economic system as we know it: one built on trillions of obligations to the future, also known as debt, also known as paper money.
As such we are left scratching our heads: if Singer is really advocating shorting the entire closed monetary system, why short bonds? After all, you may be right, but... in what denomination do you get your profits paid out: Dollars? Worthless. Euros? Just as worthless. Yen? Yeah, funny.
The point is that for Singer to be right, and he will be right one day, one can't bet on a collapse of the current monetary system with hopes of being paid out in claims of the current monetary system.
It just doesn't work.
Which leads us to believe that the real message in Singer's latest letter is what is unsaid. Yes, bonds will crash, and stocks will explode in a hyperinflationary supernova, but the currency they are denominated in will become worthless the moment the claim is transferred. But one thing will remain: the thing that has stood the test of millennia, and has survived all man-made monetary crises to date. The one thing that will also survive the next market crash. That one item, of course, is what the former Fed Chairman and current blogger, called nothing but "tradition" (which he then admitted he does not really undestand).