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Welcome to the Dogpile


The past couple of weeks have seen a rout of long-dated government bonds across the world and a sharp steepening of the respective yield curves. Commentators have tried to explain the move in terms of investors worried about a complacent Federal Reserve with regard to inflation. I think that is nonsense. Sometimes, big moves like the ones we are currently witnessing are all about trader positions and very crowded trades. I wrote a piece a while ago titled “Avoid the Pain Trade.” The “Pain Trade” refers to the market’s uncanny ability to find a position (like being short a certain currency or commodity or over-weighted in duration, etc.) that a good portion of traders hold, and violently change direction on a dime, destroying everyone in the trade. The Pain Trade evolves something like this:

  1. A particular position looks very attractive and makes a lot of sense. Let’s say it is buying long-dated Treasury bonds, because there is a tremendous need for bond duration due to central bankers gobbling up more duration that seems available. So, you buy the long-dated Treasury bonds. Maybe you don’t want to be outright long duration so you sell shorter-dated Treasuries against it. You are in a trade called a yield curve flattener. You are betting that the gap between long-term rates and short-term rates narrows.

  2. The trade goes in your favor almost immediately, and soon you notice that you are surrounded by like-minded traders all jumping in with you.

  3. The first time it goes against you, you and all your new friends yell, “Buy the dip.”

  4. Step number three occurs about nine or 10 times, further increasing your profits, as well as a well-developed sense of hubris.

  5. Suddenly, something happens out of the Something like rumors that central banks will stop buying the bonds that you are buying. It dawns on you that your initial trading strategy was not based on fundamentals. Rather, it was based on the extraordinary monetary policy of central bankers. Therefore, why should it surprise you that the trade can collapse on even a rumor that the central bank will stop buying the bonds you are buying?

  6. Now, you and thousands of your new “trade-friends” are all trying to get out of the trade at the same Moreover, traders who were not in the trade, pound you by taking the other side of your trade, pushing it further in your face as they laugh at you.

  7. Step six is what is referred to as “The Dogpile” This is where the entire market jumps on you until you crack. You get out of your trade, realize your losses and cry.

  8. Soon, after you have taken your losses and cried, the pressure on your trade is lifted, and the central bankers deny that they are going to stop buying long-dated bonds.

In my opinion, this is what has happened with the latest selloff in the long end of our Treasury curve. There was an unsubstantiated rumor that next Wednesday, when the Bank of Japan (BOJ) has its policy meeting, they will lower their policy rate from negative 10 basis points to negative 20 basis points. To compensate Japanese banks for the pain and suffering of Negative Interest Rate Policy (NIRP), they will eschew buying long-dated Japanese Government Bonds (JGBs) and help the banks by steepening the Japanese yield curve. Personally, I think that additional central bank tinkering is just piling one bad idea upon another one. However, my opinion didn’t stop a mad dash of traders dumping long-dated JGBs. The Japanese 30-year (I am using JGB 51), as of this Wednesday, dropped nearly five points in the first two weeks of September. This rout spilled over to the long-dated government bonds of Europe and the U.S. The spillover into Treasuries is what caused the “Pain Trade” scenario mentioned above. Additionally, there has been an unraveling of another “Pain Trade.” Many investors and traders were selling volatility all summer long. Now, there is volatility, and those traders and investors are caught off-sides. If they sold puts on long-dated Treasury futures, they are getting longer in duration as the market sells off. This forced them to sell, exacerbating the rout in the long end.

Therefore, I do not think the end is nigh for the great bond rally of 2016. I do not think the BOJ is going to abandon the long end of the JGB curve because raising long-term borrowing rates will work against their goal of sparking economic growth and inflation. Additionally, one of the BOJs problems is that they are running out of things to buy! Cutting out the entire long end of the JGB curve just compounds the problem. If they don’t want to hurt the banks, then they should just leave the policy rate alone.

I continue to like the long end of the Treasury curve, and I continue to believe that risk markets are in perilous shape. Events such as this morning’s U.S. Department of Justice (DOJ) $14 billion fine of Deutsche Bank for their residential mortgage “missteps” (and Deutsche’s telling the DOJ to stick it) are out there in abundance. Volatility has returned. Continue to prepare accordingly.

Member SIPC & FINRA. Advisory services offered through SWBC Investment Company, a Registered Investment Advisor.

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