Lessons on the Short Treasury Trade from 10Y JGB Futures

JM
March 15, 2010

I’ve seen too much about the “trade everyone should be into”—shorting Treasuries. Let’s
break this trade down.

• The economics of the trade is poor

• Even though the Fed is jonesin’ for inflation, there is a bet against the Fed embedded
in it on some convoluted level
• It is an extremely crowded trade

The short treasury trade has features that make it a bell-weather for the multi-layered
screwdness in which the world finds itself.

On the surface it looks pretty appealing. What with a commitment to being irresponsible on
the part of the Fed, and global economic recovery on the other hand. It a long position on
rational economic policy, right?

The Economics of the Trade

So let’s say you short the 10Y and pay out around 375 bps and margin or borrow fees to
boot. As short-term interest rates are around 25 bps (more if you are less than top-notch),
you have a negative carry of at least 400 bps. This is not a healthy trade. Shorting sets
you back 4.00% per year for ten years independent of the direction of the trade. You need
400 bps per year just to cover cost before you see any P. Max loss from a yield perspective
is if the yield goes to zero. This implies a 40% capital loss in one reality-inducing stock
market crash.

Regarding upside, is inflation really that underpriced here? Not too hot a trade IMHO.

Don’t Mess with a Cornered Rat

Even worse, there is that serious Fed perversity working against you too. The fact remains
that the MBS paper on the Fed balance sheet has virtually guaranteed that a spike in
mortgage rates isn’t an option. This means that the Fed will not stop buying debt even if it
runs the risk of destroying itself. If they stop buying debt, they will destroy their reason for
existence: United States debt management. If the Fed destroys itself, then the financial
system is pretty much dead. There is no way they can stop purchasing govvies for a good
ways yet. The Fed may want inflation, but they won’t allow the treasury market to have
sequential failures. In other words, there is a hard lower bound on how far their crazy
antics will go.

Crowded Trade Problems

Fear the crowded trade. For starters, note that taking out a 30yr mortgage is a very similar
thing as shorting a 30Y Treasury, and the housing bubble put the United States consumer
all-in on the set-up. So if you bought a $1,000,000 McMansion at 6% interest, you get say
5% back in tax offsets. The loss was cool to handle because property prices were rising in
excess of 1% a year.

But now we have declining home prices, mortgage rates less than 5%, and you get 5% back
and now nobody wants to borrow. Why? Because property price deflation doesn’t offset
what was once a breakeven or better. When there is a real return on cash, it builds a self-
feeding cycle of deflation. Welcome to the hagfish economy where everyone becomes a
bottom-feeder.

This is SO JAPANESE… I am mystified that people don’t see it.

Back to Japanification

Clever traders in Japan had the same views about shorting JGBs back in the nineties and
naughts as we do now. Trade of the decade indeed. It ended up being called the
“Widowmaker”.

How long can the Fed keep the game going? All predictions fail, and I won’t insult your
intelligence by giving you one here. It will go on until it doesn’t. But the Widowmaker can
tell you something about how long the game can go—not just in years—but in scope.

There’s plenty of room for you to get screwed by the Fed here. Take as analogy the central
bank of Japan. The Bank of Japan held up to 65 trillion yen of long-dated JGBs from 2002
to 2009. By the way, it looks like they have reloaded for another deflation fight coming up.

Shorting treasuries has

the character of buying
SPY puts starting in May
of 2009. Even when the
obvious consensus
doesn’t come to pass,
people persist in the
trade. Example needed?
For the five years prior to
the property bubble
bursting, 10yr JGB
futures vol traded + and
– minus around spot
yields. Not so post
bubble: 10yr JGB futures
implied yield was
consistently higher than
the actual yield for over
twenty years. See below.
Source: Bank of Japan, Datastream

These persistent, even manic futures positions show that the consensus expectations can be
wrong. And don’t mess with the power of a central bank. The reality is that one can be
wrong a long, long time before one is finally right. And when you finally turn money good,
it doesn’t make up for the pain.

Source: Bank of Japan

Other Strains Of the Deleverage Disease

Maybe this trade doesn’t boil down to betting for or against the Federal Reserve and their
crazy playing chicken policy at all. Maybe it boils down to the inability to get anyone
rational to borrow an asset that has lost value for the last 28 months. Again, the lesson is
Japan. QE, multi-year fiscal stimulus, the context of a growing international economy: none
of it mattered in the least to CRE prices. So now the United States consumer is baked, the
financial system staggers as good as it does only because they can lie about their balance
sheets, and world economy is so fragile that unsustainable government stimulus programs
are the real growth engine.

Japanese Commercial Land Prices, 1975-1998

Source: Japan Real Estate Institute

There’s something to be said for buying puts, and the people who love doing it. After all,
for this train-wreck to end well, every nation needs to cooperate, but with every passing
day the benefits of cooperation evaporate a little more. Put buyers do make a mint once in
a blue moon.

Maybe Japanification is just one strain of a much larger epidemic that can be traced back to
1989. Perhaps the spark that twenty years later started a global wild-fire was the Soviet
Union collapse.