The New Widowmakers
What is a “widowmaker”? Merriam Webster defines it as “something dangerous to a worker’s life or health”. More specifically the term comes from the logging industry and describes a loose limb hanging high in a tree that falls on and kills a logger. On Wall Street for the last 25 years or so, it has had a somewhat different meaning. Over that time – which roughly matches my time in the investment industry – the idea that Japanese Government bond yields had nowhere to go but up has been a persistent and consistent theme. The list of traders who have tried to profit from what has appeared for all that time to be a no brainer of a trade – short JGBs – is long and distinguished. And none of them has been successful yet in making any money on the trade.
The only people who have consistently made money in the Japanese market for the last two decades are those who bucked the consensus and bought JGBs rather than sold them. They have benefitted not only from the fall in Japanese rates but also the persistent rise in the Yen. It may be that that era is coming to an end with Abenomics but I have my doubts. There is still today a long list of pundits predicting the demise of the JGB and the Yen with John Mauldin – who has called Japan a bug in search of a windshield – and Kyle Bass – who has been predicting a fiscal crisis in Japan for the last four years – leading the pack. I suppose they could be right someday but with the ability to print Yen to pay their bonds to a mostly domestic, aging, risk averse audience and an economy that refuses to shift out of neutral, it could be a long time coming.
The widowmaker label could equally apply to US Treasury bonds which have been falling in yield for most of my adult life and my entire investing career. We hear all the time about the great bull market in stocks that lasted from 1982 to 2000 before succumbing but we hear less about the bull market in bonds that started around the same time – and is still going strong today. Indeed, an early 1980s investor interested in capital gains would have saved him or herself a lot of angst and volatility by just buying some 30 year zero coupon Treasuries and ignoring stocks altogether. Just as the traders who shorted JGBs since the early 90s have all been carried out of the market ring feet first, anyone trying to short US Treasuries during that time only received a very brief reward before getting caught by the market haymaker of lower rates.
And so it has been this year as well. As I’ve noted several times recently, the broad consensus that the Fed’s tapering of QE would lead to higher rates has been decimated this year by a relentless and seemingly mysterious bid for bonds. The 10 year Treasury note has fallen in yield from 3% to 2.5% (and briefly below that last week) since the beginning of the year producing a return that has far outpaced a flat stock market. A myriad of explanations have been offered for the drop in yields from the turmoil in Ukraine to short covering by traders who have already reached their pain point. I tend toward the Occam’s Razor explanation. Bonds have rallied because growth expectations for the US economy are getting worse, not better.
Another way to look at the 10 year yield is as a proxy for nominal growth. Over the long term, the 10 year Treasury yield has been a pretty good proxy for nominal GDP growth. It makes sense that interest rates should track economic activity in an economy. During times when there are plentiful profitable investment opportunities one would expect the demand to borrow and invest capital would be high forcing up interest rates. During lean investment times, the reverse would be true. To be more accurate, the yield of the 10 year Treasury is actually an indicator of two things: growth expectations and inflation expectations.
The easiest way to judge inflation expectations is to look at the difference in yield between similar duration TIPS and nominal Treasuries. Subtract the TIPS yield from the nominal bond yield and the inflation expectations embedded in TIPS is revealed. This year the 10 year breakeven (the inflation rate at which nominal and inflation protected bonds offer the same real return) is basically unchanged moving less than 0.1%. Since NGDP is composed of real GDP growth plus inflation, the inevitable conclusion is that growth expectations have fallen producing a rally in nominal bonds and TIPs (to keep inflation expectations the same).
This promises to get a lot more interesting over the coming months assuming that QE is really ended as currently scheduled. Every iteration of QE so far has seen a rise in inflation expectations just before and during QE and a fall in those expectations after its end. This time it appears the fall in inflation expectations has front run the actual end of the program. The TIPS market shows a drop in inflation expectations that coincides with the first mention of tapering last spring and a flattening of those expectations once the taper was incorporated into TIPS prices. Will inflation expectations fall even further once QE is finally over? It certainly seems possible if the current expectations for growth are anywhere close to accurate. If growth fails to revive after the polar vortex and inflation expectations start to fall again, a lot more widows are going to be made on the short side of the Treasury market.
Treasuries are not the only widowmaker trades out there. Another prominent one the last year or so has been the long US dollar trade. While not as extreme as the sentiment on bonds, dollar bulls have not exactly been scarce particularly when the counterparty currency is the Euro. Everyone it seems has been expecting better growth in the US and continuing problems on that front in Europe. While the Euro finally pulled back a bit over the last week after Draghi’s comments on future ECB monetary policy, falling growth expectations in the US would not seem to be supportive of a higher value for the dollar. It might not mean a Euro rally since they appear to be growth challenged as well, but other currencies are continuing to move higher against the buck. The Australian and Canadian dollars have been strong recently along with the British pound. Emerging market currencies have also staged a pretty good recovery with the Brazilian Real and Indian Rupee doing particularly well. While I’m not convinced that Brazil has done anything to warrant the move other than hosting the World Cup, I am more encouraged by the election of a party promising major pro-growth economic reforms in India (although breaking the stranglehold of the Indian bureaucracy won’t be easy).
One last widowmaker to mention is the one that has put me on death watch the last year. Being skeptical of stocks while the Fed is determined to move them higher in pursuit of the ever elusive wealth effect has not been comfortable or rewarding. I do believe though that this is one where the injury will not prove fatal. The old saying that one should not fight the Fed only works until it doesn’t. Stocks had no problem falling from 2000-2002 despite frantic Fed rate cutting. Neither did they stop falling in 2008 while the Fed was frantically pulling every lever it could get its hands on. So, I would characterize the stock market bears as wounded, but in the immortal words of Monty Python’s brave knight, not dead yet. It’s just a flesh wound.
The lesson to be learned from the widowmaker trades is that the consensus is often wrong especially when sentiment is at an extreme. No brainer trades rarely work out as expected. Contrarian investing – taking the other side of those consensus trades – is not easy but it is often profitable. The US Treasury bull market has defied the odds for 30 years and yet traders keep trying to call the top. It will come someday but for now I’d suggest backing away from the shade of that tree.
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