BUND UGLY

Mod Note (Andy): Originally published 1 May 2015 in The Daily Dirtnap. WSO readers qualify for a $100 discount to Jared's Daily Dirtnap daily market newsletter...just email [email protected] and mention "WSO Monkey Discount" You can follow Jared on twitter at @dailydirtnap

No secret that I’m a bond bear, but I’ve shut up about Europe, because, why impale yourself?

Source: Bloomberg

Party is over.

You probably also saw that the DAX was down a horrific 4%. I’d put a chart in here, but we need space for more important charts.

So. If this is a top for European bonds, what does that mean?

I really don’t know.

I wasn’t kidding yesterday when I wrote in the body of the email that I felt like I should hedge something but I didn’t know what to hedge.

I’ve been in these situations before, where I don’t understand the trade, and I don’t know what’s going on.

Usually in these situations I’d be better off if I just sold everything and headed for the hills. I don’t want to sell everything, but I’ll compromise and sell one thing.

I’ve never been one of these big Europe macro mavens, so I’m afraid I’m not going to be much help here, and from what I understand, there are reasons to hold German (and other European) paper above and beyond the investment return, or the lack thereof. Collateral and such. All over my head.

I’m going to fall back on the idea that anything that has a negative yield is probably a bubble. Back when I was teaching my finance class last year, I was asked about negative yields. I think German 2s had negative yields at the time, or at least they did, around the time that people thought the euro was going to come apart. And Swiss 2s had negative yields, too.

So this student asked me, very innocently, why would you invest in a bond/bill that had a negative yield? Why would you lose money on purpose? That doesn’t make any sense.

I wanted to say something about the field of finance/economics where people contort themselves into doing things that don’t make any sense. But I said, look, there are two reasons:

1) If you think you will lose more money doing something else
2) If you think the capital gain outweighs the negative coupon

Let’s talk about 2) for a moment. If I own XYZ German paper, I literally get money sucked out of my account every six months. So I guess the only way this works is if there is deflation, which is a bit academic, or...the price of the bond goes even higher!

Remember Minsky:

Hedge borrower: Can make debt payments, covering interest and principal, from current cash flows.

Speculative borrower: Cash flow can service debt, cover the interest, but you must refinance.

Ponzi borrower: The appreciation of the asset is sufficient to refinance the debt but cash flows are not sufficient to pay interest in principal.

We talked a lot about Minsky during the financial crisis, but not much since then. If you think about it, buying this negative-yielding paper is a lot like Ponzi finance.

So I think that there cannot be a prolonged period of negative interest rates, because of the distortions around the zero bound. It’s my opinion that any period of time with interest rates below zero is going to be very brief.

Put another way, I think we just saw the tippy-top of a bubble.

Can’t know for sure, of course. Gundlach has had a few interesting points on this. 1) that with negative interest rates, gold is a positive carry trade. 2) that if you have negative interest rates, you can short the bond on a leveraged basis and earn pretty significant positive carry.

Shorting earns positive carry! Where are the carry monkeys?

It’s not that straightforward, because you have to actually borrow the bond in the repo market, but still.

I’ve kept my mouth shut until now, because who knows? But the trend is broken, risk is getting caned, and it looks like the world is going to have to deal with (gasp) higher interest rates.

Of course, we haven’t even discussed the whole issue of inflation. The demographic deflation argument is pretty compelling, but you know what they say about the best-laid plans.

 

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