Enzio's Clock

Background

1.Lower bond yields mirror a stronger yen 

Risk aversion has strengthened since the end of this October. 

Long bond yields peaked at the end of this October. Whilst corporates are still yielding 2.19 percentage points - or about 50% - more than their government cousins, corporate yields have fallen by 28% - and government yields by 42%. That government yields have fallen so strongly relative to corporate yields suggests that people are still very risk-averse.

Mirroring this risk aversion is a stronger yen. In our Advice Tracker, you will see that since we recommended this position, it alone has risen some 34%; since the end of this October, it alone has gained 10.6%. This strengthening means that people keep unwinding the positions that they previously financed with cheap yen. So the following happens: they sell their punt, and then convert its proceeds back into yen and re-pay their yen debts. 

2. Why we are shorting long bonds

So, with bond prices rising so much (i.e. with yields tumbling), why on earth would we be so stupid as to recommend shorting long bonds? We are way to early on this call (see part 3), but it just won't leave us. Here is why.

First, because the Economic Time™ keeps worsening: the excess demand for money is intensifying because banks refuse to lend, and thus, the excess supply of goods is intensifying because companies cannot sell their goods and services.This part of the cycle you might call "winter" - and it performs a very important function. See the paragraph after this next one, please.

Secondly, this means that the US government is bailing out its friends (i.e. its campaign financiers): it is trying to skip a cycle.  The "club members"  in the banking industry were fed by "Santa Paulson", as Sin-ming Shaw quipped in the South China Morning Post of 20th December 2008, p. A13. He went on to write that "Financial consultants estimate that between US$ 20 billion and US$ 23 billion in bonuses will be paid on Wall Street this year." What do you think of this, reader? Meanwhile, the "Big 3" car makers made sure that they got to hide behind their self-made "too big to fail" mistakes. Now the Fed is morphing into the most "Chinese" hedge fund around: no transparency!  Sin-Ming writes that the Fed has lent US$ TWO trillion to financial institutions. "Bloomberg News is suing the Fed under the Freedom of Information Act to win disclosure of what, if any, collateral Wall Street banks have posted. The Fed is contesting the suit on the grounds of 'trade secrets' and 'fragility of confidence.'  Many financial experts believe transparency is the key to stability. Keeping the markets in the dark tends to increase the risk of panic due to miscalculation and unwelcome surprises." Amen!

But when you skip a cycle, you disallow what should happen during said cycle actually to happen. Winter is all about killing that off that should die. Call it Darwinian. Fine. If you don't allow winter to do her work, then when the growth-eager youngsters come out in Spring, they are held back by these over-fed, pathetic dinosaurs wailing "please save me because I am just to big - or important - to fail".

Thirdly,we have warned you of our misgivings concerning the extravagant expectations presaging Obama's Presidency. The strong RMB erodes the RMB value of China's holdings of dollar Treasury bonds, and this constitutes  one reason for China to buy less US dollar Treasury bonds. Once this news inflames markets, watch US dollar bond yields plunge. 

Fourthly,  we have seen quantitative easing before in America herself; Bernanke-san is risking a repeat performance of 1951, the last time that the Fed bought bonds in a bid to keep a lid on yields. The result is that real yields plunged to a NEGATIVE 16.5%. Way to go, boys. Well, we have said that the Fed risks becoming the world's worst-run hedge fund  - deja-vu?

Finally, is the market perhaps looking the wrong way? Currently, long bonds are being bought because of deflation. But we see things differently: once the Chinese stop buying U.S. debt, and once the markets realize that government and private-sector bond issuances are about to explode (see next), that "excess demand for money" has to rocket. This means: higher yields, and by definition, this means that bond prices must plunge. 

3. The matter of timing

Out the outset I gave you an investment "health" warning: my "calls" - warts and all - usually are up to six months early. We hope that this will be dis-proven this time;  bedlam is about to hit, so we read. 

In The Economist of 6th December 2007, p. 81, we read:

" Competition for capital is bound to increase...given the coming torrent of government debt issuance.  Auditors also  want to be reassured about refinancing prospects well before maturity dates so they can sign off on companies as going concerns. With little obvious benefit in waiting, many expect to see a concerted effort by companies to renegotiate funding facilities early in 2009, once the year-end squeeze is over..."

In a subsequent article in the same issue, on page 83 f., we read why this rush is imminent:

• "Liquidity always tightens in late December, when markets are closed and banks tidy up their balance sheets";
• "An exacerbating factor this year is the demise of the investment banks" Bear and Lehmans are dead; Goldmans and Morgan Stanley have become commercial banks with a calendar fiscal year from 2009 - and both are under huge pressure to shrink their balance sheets, "...all the more so for Goldman, which is expected to report its first quarterly loss......Brad Hintz of Alliance Berstein says that ..the securities industry will provide...one third less (financing) than in 2007"
• "Nor does it help that lenders have become very choosy about collateral. In August 2007, a typical asset=-backed security would secure a loan worth 95% of its face value; now it fetches a mere 30%."

4. How to Make Money Off This Idea

1. Always consult your financial adviser first.
2. Have a look at the ETF, TBT:US. According to Bloomberg, "UltraShort Lehman 20+ Year Treasury ProShares is an exchange-traded fund incorporated in the USA. The Fund seeks investment results that correspond to twice (200%) the inverse of the daily performance of the corresponding Treasury Bond."
3. IF ANYONE HAS A SIMILAR "SHORT" ETF  on long-dated USD corporate bonds please share your information with us! We'd prefer to go short the long-dated corporates than the long-dated governments, on account of higher volatility.