What Just Happened In The U.S. Treasury Market? And Does Bill Gross Have A Crystal Ball?
May. 8, 2015 1:00 PM • tlt
- Commentary from Bill Gross, Paul Singer, George Soros, Jeff Gundlach, and others has brought the discussion surrounding the "end" of the bond bull market to mainstream media.
- Will the sell off being seen in treasuries be orderly or should market participants be concerned about a disorderly exit?
- What is the best way to profit from the current situation?
Over the past three weeks, international debt markets have seen unprecedented successive days of selling. The jump in German Bunds and impact on U.S. Treasuries (TLT. TBT ) has been well documented by media outlets (this past week, front-page stories on Bloomberg and the New York Times covered the topic). Let us briefly recap the move in the U.S. 10-Year Note, German Bund, and TLT over the past 10 trading sessions.
- TLT smashed through its 20, 50, and 200-day Simple Moving Averages (SMA) and the 50-day SMA crossed below the 100-day SMA.
- Jamie McGeever of Reuters: As of 05/07, German Bunds had sold off 450 ticks in 1 week, and 700 ticks in 2 weeks. The worst sell off since the reunification of Eastern and Western Germany.
TLT data by YCharts
TLT Price data by YCharts
As I documented in my summary of the Grant's Interest Rate Observer Spring Conference. Bill Gross and Paul Singer both spoke to the end of the three-decade bull market in bonds.
Gross spent an hour speaking on what he calls the "new normal," a theory that he echoed in his melancholic letter released on Monday, titled "A Sense of an Ending " (wait until Sunday afternoon to read this, it's depressing). He states,
"Policymakers and asset market bulls, on the other hand speak to the possibility of normalization - a return to 2% growth and 2% inflation in developed countries which may not initially be bond market friendly, but certainly fortuitous for jobs, profits, and stock markets worldwide. Their "New Normal" as I reaffirmed most recently at a Grant's Interest Rate Observer quarterly conference in NYC, depends on the less than commonsensical notion that a global debt crisis can be cured with more and more debt. At that conference I equated such a notion with a similar real life example of pouring lighter fluid onto a barbeque of warm but not red hot charcoal briquettes in order to cook the spareribs a little bit faster.
Disaster in the form of burnt ribs was my historical experience. It will likely be the same for monetary policy, with its QE's and now negative interest rates that bubble all asset markets."
Though Gross has predicted the end to the bond bull market multiple times before, most notably in February of 2013 and again in April of 2013, he emphasized that this time was different. Why? Negative interest rates in multiple sovereign European nations are a simply unsustainable, never before seen phenomenon with unknown repercussions.
Equally fascinating was Paul Singer's thesis termed "The Bigger Short" (a second coming of his 2006 presentation, "The Big Short"). Singer lays out the case for shorting treasury 10-Year notes and long dated bonds under the presumption that empowered central bankers will not be able to react to an unexpected move in inflation. Additionally, Singer believes the herd currently collecting historically low returns will eventually realize that negative rates of return, and even rates of return below 2% do not adequately compensate for the risks they are taking. In summary, a single catalyst, be it inflation, a political event, or social event could spark a rush for the exits.
"I also don't understand why bondholders believe that if inflation bursts its commanded boundaries despite central bank scolding, the central bankers can, indeed, as a former Fed chairman and now unapologetic citizen blogger has said, cure it in '10 minutes.' Imagine the ruckus in global financial markets if inflation surprises everyone on the upside and the right policy rate should be 2 percent, 4 percent or higher."
The backdrop for both of these speeches was a luncheon presentation from Michael Hartnett, Managing Director and Chief Investment Strategist at BofA Merrill Lynch Global Research. Hartnett provided attendees with a 200-page handout of charts placing into context the current position of today's credit markets. He described the current "Maximum Liquidity"
environment where 83% of the world's market cap is under the influence of ZIRP as the shepherd that has led certain credit markets to never before seen levels.
The timing of both of these men's calls is perhaps lucky, certainly eerie, and should not be ignored. Most of the investment community agrees that at some point interest rates will rise, negative yields are illogical and unsustainable, and the main question is when and how this "take off" will occur. With the June FOMC meeting quickly approaching and the possibility of rate hikes on the horizon, was this past week a sign of things to come?
The greatest concern surrounding this recent move in long dated treasuries is the lack of liquidity in the treasuries market. On October 15th, 2014, the U.S. 10-Year Treasury market experienced a flash crash. As Jamie Dimon explained it in his annual letter to J.P. Morgan shareholders, "Treasury securities moved 40 basis points, statistically 7 to 8 standard deviations - an unprecedented move - an event that is supposed to happen only once in every 3 billion years."
Most surprisingly, the cause of this flash crash remains unknown. It can be assumed that the same issues that impacted the market on 10/15/14 remain today. The concern here is that as rates begin to take off and large market participants begin to move the willingness to speculate in the current macro interest rate environment (500-year highs) will not exist. The risk is not that there is a lack of capital (of which, there is plenty), but a lack of desire to intermediate risk in such an unnatural, Federal Reserve Bank dominated market. In fact, this is the greatest risk of all.
If institutions, brokers, and intermediaries (which in this day and age largely means computers), are unwilling to allow a liquid environment for long-term interest rates to transition higher, we may be in for an ugly ride up. I am not a doomsayer or against the electrification and modernization of financial markets. Instead, I am saying that the interest rate environment today is in such a place as to be unpredictable. There is no back-testing against short-term negative interest rates and there is no back-testing against the removal of Federal Reserve Open Market Operations (or heaven forbid, the selling of Federal Reserve-owned long-term securities).
Interestingly, you can already see the small concern of a black swan event creeping into the options markets of TLT. On April 6th, 2015, I purchased downside Jan. 2017 Puts on TLT (Strike prices of $110 & $90). The $110 strike Puts cost $4.80, the $90 strike Puts cost $1.09. As of May 7th, 2015, the same options cost $7.75 and $2.20, respectively. As you can see below, Volatility Skew, both horizontal and vertical, has begun to increase over the past 10 trading sessions. Additionally, simply looking at the gains of the $90 Puts (
+88%) vs. the $110 Puts (
+53%) you can see long term, tail risk insurance premium costing more than nearer to the money downside insurance. In my opinion, if the interest rate market continues to sell off, and if the risks of an illiquid, "run for the exits" type of move continues to get priced into TLT options, downside TLT LEAPS remain an interesting trade to be in.
Horizontal and Vertical Volatility Skew (Courtesy of Optionistics)
Of course, the variant view on this trade is that the move over the past three weeks of trading was merely a correction and in fact, interest rates should remain lower for a considerable amount of time as the Fed remains patient. Additionally, one could have the opinion that markets are inherently efficient and any participant (however large their size) will be able to exit the long dated treasury market when they so choose. In either case, I am willing to pay my option premium to play until January 20th, 2017. as the swan's neck rises.
Technical View of TLT (Courtesy of FinViz)
This blog post provides an excellent analysis from a market maker's perspective of what is happening in the credit markets, I highly suggest the quick read.
Disclosure: The author is short TLT.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.