A few thoughts on bonds

Between the bank holiday in the UK and the Sohn conference in New York, it was unsurprisingly a very quiet start to the week yesterday.  Macro Man availed himself of the soporific trading conditions and the brilliant sunshine to climb some of the local hills on his bicycle, and returned after a couple of hours to find the SPX virtually unchanged to the decimal place from the time of his departure.   Says it all, really.

One thing that grabbed his attention was an article from Bloomberg entitled "Can't Find Enough Treasuries to Buy?  Here's Why."  His first reaction to the story was "this would have been a lot more useful in January", though that's perhaps a trifle unfair on the journalist, whose job is to explain rather than forecast.   His second reaction, however, was "well, if that's not the beginning of the end of the bond rally, it may well be the end of the beginning."  Although this was hardly the cover of The Economist, it is still worth noting when market developments become sufficiently entrenched to attract journalistic attention.

That having been said, it still looks to Macro Man like 30's are going to 3%.  Other than a bit of yield support around 3.30%, there isn't much technically to prevent long bonds from taking a peek at a 2 handle.   The latest CFTC data has duration-weighted bond futures positioning still short, and frankly if bonds couldn't meaningfully sell off last Friday, then it probably isn't going to be data that turns this sucker around.


Would Macro Man go long bonds here?   Not necessarily.   Although one could argue that a 30 year long could use a yield stop around 3.55% (the cluster of lows in Feb-March as well as the mid-April yield high), thus offering a decent risk/reward, he generally eschews trading the long end save at clear price or economic extremes.  His rationale is that the policy rate anchor is pretty tenuous, and markets can choose to interpret the same set of factors in radically different ways depending on flow, positioning, and even regulatory factors.  In other words, it can more or less go wherever the hell it wants, and he doesn't feel like he has an edge.

Curve trades are normally a bit better, because they strip at least some modicum of the (oft-inexplicable) market beta out of the equation and provide some degree of protection in getting the fundamentals wrong.   Of course, curve trades are generally directional in and of themselves, so it's not like all risk is defrayed.

Although markets have been short US bonds in aggregate, hidden in that data is a reasonably sized 5-30 flattener.   One would have to think that these trades were established with a bearish tilt in mind, expecting Fed normalization to lead the belly higher in yield.   Curiously, the trades appear to have worked splendidly...as a bullish trade, given long-end outperformance.   Still, happy days, right?

Well, maybe.   Remember, these trades have some of the characteristics of bearish trades, including, unfortunately, the negative carry/rolldown.   Macro Man recalls attending a traders' meeting once when the senior figure asked why no one seemed to be able to make money running short rates.  This environment is a perfect example, in more ways than one.   Not only do bond bear markets typically "enjoy" vicious short-covering spikes (2014, anyone?), but you really have to trade them on a hit and run basis due to the carry.

Consider the 5-30 flattener mentioned above.    The curve peaked at 2.53% in mid-November and has subsequently flattened to 1.73% in close to a straight line.  Imagine you did a 5-30 flattener in swap space, 3 months forward, at the ding-dong highs in the curve.   After that 3 months, you must have had it off, right?  Ummm, no.   In fact, you broke even, as the forward was some 30 bps lower than the spot flattener, and there was....30 bps of flattening in that 3 months.   Ouch!  Indeed, the maximum profit that you would have made from this trade during the 30 year rally was 18 bps, and that's if you did it exactly 3 months ago.  For most of the year, the trade would have been offsides or flat.  (The chart below depicts the spot 5-30 curve with the 3m forward from 3 months previous.)


And that, in a nutshell, is reason #3456343 why 2014 has been such a scuffle.   This flattener has been one of the most pronounced trends in the macro space in 2014, but even with virtually no pullbacks it's been difficult to monetize.  The good news is that the carry isn't quite as prohibitive now....the bad news is that the spot curve is as flatter than at any point since 2009.  Good luck if there's ever a pullback!

So it's damned if you do, damned if you don't.  Suddenly, the prospect of a another round of hill climbs doesn't sound so painful....


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Anonymous
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May 6, 2014 at 12:15 PM ×

Completely unrelated... The new font colour is much better. Thanks !

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Anonymous
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May 6, 2014 at 1:40 PM ×

Silly question ... Why would one do that 5-30 flattener using forward swaps? Is it to avoid paying/receiving intermediate coupons?

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Macro Man
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May 6, 2014 at 1:43 PM ×

Yeah, that would be one reason. Another would be to avoid the mandatory SEF clearing that comes with doing 'benchmark' swaps.

Really though, I used the 3m fwd example as it is the easiest way to show the negative carry graphically without a system better than the Bloomberg courtesy login.

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Leftback
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May 6, 2014 at 2:13 PM ×

Quality stuff. Almost as though MM could read LB's mind. LB has been long the long bond all year, with a few efforts to hedge, which have generally been what MM would call "execrable attempts at short-term trading". Other than the weeks where I tried thinking, it's worked really well, in other words. Even better have been last year's bombed out rate-sensitive yield vehicles, REITs, preferreds and so on.

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Leftback
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May 6, 2014 at 2:38 PM ×

On an unrelated topic, Betty is currently tottering around on 8 inch heels, and knocking on the door of 1,70. Time for a tumble? Or is this just the usual rule of LB visiting UK in a few weeks, so £ soaring?

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Anonymous
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May 6, 2014 at 3:45 PM ×

C says
LB,
have you not heard ,the Uk is boooooooming and Betty will be banging buck 2 :1 before you know it. Betty so deserves to be wearing Jimmy Choo's !
Unfortunately, when Mr exports global sales staggering on FX translation meets Mrs electioneering policy job done and votes bought, then Betty and pavement will be an unhappy collision.

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abee crombie
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May 6, 2014 at 5:14 PM ×

Euro going for 1.40 as well, AUD near highs, JPY looking to break out of recent range and CNY strength. Even RUB is joining the party. Only CAD cant buy a bid (everyones fav cross short)

LB, I guess you and I arent the only ones going on a European vacation ;)

MM, cheers on the flatenner real world explination. Spreads are always easy on charts, hard to execute

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Polemic
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May 6, 2014 at 7:03 PM ×

my new role sees me in the EU peddling UK services and today had front end of a "Eur/gbp moves not helping us" comment in a meeting re proposed and revised budgets. small fry stuff and of course fx hedging strategies were suggested by yours truly to surprise if the creatives the other side of the table.. suddenly the theoretical becomes very real.

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abee crombie
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May 7, 2014 at 3:47 AM ×

Mr macro man. While you are studiously commenting on the markets, might I suggest a topic soon to be on the tips of he financial press, the Feds reverse repo operations. In a recent bberg interview Einhorn had with the beard it seems The Fed believes they have the tool box needed to control excess reserves should a time come when banks actually decide to use them.

But as grants writes this week the Feds rrp program is an open invitation on bank runs as financial institutions will by pass the inter bank market in times of stress and seek to repo directly with the fed who is full of assets. Though apparently the fed is aware of such risks.

Any thoughts. Is the repo market operations going to be a game changer.

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Hedgesarefordogstopisson
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May 7, 2014 at 10:23 AM ×


With Italian/Spanish yields making new lows amidst the liquidity slosh, my question will be for the real money guys (who are under-invested/short duration); at what level would they cut and start chasing ?
Can't be too far away right?

Not to mention the summer period + Brazil world cup spanning through May - July, death by a thousand cuts* on the -ve carry

PS: noted the small amendment on your 2nd screenshot =)

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Simon White
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May 8, 2014 at 3:06 PM ×

Not be the bearer of bad news, but is the chart showing 5s30s swaps 3m forward correct? I graphed it and it looks totally different, and has the forward curve about 12bps lower at the Nov highs, not the 30bps you mention. Is yours right? 10 bps a month neg carry for a curve trade sounds a lot

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Anonymous
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May 8, 2014 at 3:07 PM ×

Not be the bearer of bad news, but is the chart showing 5s30s swaps 3m forward correct? I graphed it and it looks totally different, and has the forward curve about 12bps lower at the Nov highs, not the 30bps you mention. Is yours right? 10 bps a month neg carry for a curve trade sounds a lot

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Macro Man
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May 8, 2014 at 3:36 PM ×

Doh! Good catch. It looks like I mistakenly compared the forward swap curve with the spot Treasury curve, not the spot swap curve. The point stands, therefore, just in a substantially weakened form....the flattener has generally been profitable, just not quite as profitable as you might think. That's what you get when you don't have an editor....

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Simon White
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May 8, 2014 at 4:16 PM ×

No worries - I'm in a similar position. Still, you might have been pleasantly surprised by being wrong in this instance!

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