Wednesday, 25 February 2015

Exhibit A in the case against Real Money Bund positions

Following in from  the last post where I point to real money being the ultimate casualty in bonds -

I just saw and want to raise as (exhibit A) in the case against real money bond logic. (from a Robin Wigglesworth ( FT Hack) @RobinWigg tweet) which he says is from David Tan JPM Asset Management's head of rates. Here he justifies why the fund is investing in negative yield.

To understand buying German bonds on a negative yield, consider our starting point which is The European Central Bank's negative deposit rate at -20 basis points. For a lot of banks owning a five year government bond at -8 bps is preferable to placing the money on deposit with the ECB at -20 bps. (1) Secondly. whilst as an investor you may allegedly be 'paying to own the bond', bear in mind that if yields drop further, you will get a capital gain to offset the negative yield Therefore from a total return perspective the expected return will be positive rather than negative. (2)

For investors including JPMAM we may choose to own negative yielding bonds by shifting out of 2 year bonds at -22 bps into five year bonds at -8 bps because we see no prospect of ECB tightening in the near term, which would make the trade unprofitable (3). Secondly. we see a very low inflation environment for the foreseeable future. (4) In that context it can make sense to shift from shorter dated bonds into longer dated bonds at less negative yields on a relative basis.

In our view the market is getting used to negative yields. About half the German bond market excluding T bills is now in negative territory therefore investors are becoming acclimatized to negative yields (5) The ECB haven't even begun to buy government bonds and that will further reinforce the current environment.(6)

It is important to point out that Germany is actually running a small budget surplus currently so we would expect net negative supply in Germany for the next few years and at least for the entire duration of the ECB GE programme That means demand will continue to outstrip supply, effectively bolstering prices and holding down yields. (7)

Which leaves me even more convinced that real money are going to get hosed and that some of them are just winding the spring of their own demise even tighter. Let's look at the points I have numbered in the text in blue.

1) Adding duration adds leverage for the same face amount and we assume he is talking same face as he is avoiding being in cash. Adding leverage normally leads to a faster death should something unexpected occur. Interesting that he would rather pay negative yield in Germany than get positive in France on this argument. Also interesting that he isn't saying get a more positive yield by going even further up the curve. 30year? I can only assume that he is aware of a duration/risk payoff that far out but isn't mentioning it in the case of the 5yr. It may be cheaper for him to rent a vault and stick a few billion of Euro cash notes in there at 0% plus rental.

2) 'Bear in mind if yields drop further you will be paid'.  So yields fall, though how much further is a squeeze, and you get your coupon paid by capital appreciation OR yields stay the same and you lose on paying to own it OR yields go up and you are screwed on all fronts. Yet he only mentioned the first case. In fact paying to hold something only because you hope its price will go up is a characteristic of the last stage of any bubble.

3) You don't need the ECB to change anything to make the trade unprofitable. The longer bonds whip around independent of ECB and are more of a measure of expected inflation. Indeed if the ECB does nothing whilst inflation (or just expectation of inflation) picks up the 5yr will rip a hole in your face via expectations and thoughts that the ECB could be behind the curve. One of the cop outs of holding bonds is that you can run them to maturity and not make a loss even if mark to market they appear so in the interim. It is opportunity loss but you get your face value and coupon back at least. This is reversed with a negative yield where the longer you hold them the more you pay, which would suggest that come a turn, the requirement to exit will be greater.

4) It's on his expectation of low inflation forever. Even if JPMAM are right, should inflation expectations change from the rest of the market they will still be hosed. But fair enough at least a viewpoint here.

5) Sounds like my rail company who now feel that because I am used to overpaying for a rubbish service I will be happy to go on doing so forever. WRONG. I have never before heard being used to losing money as a reason to want to continue losing money in a grown-up investment argument.

6) Correct, but we all know they will, so do you suppose that this information may already have moved the price? I do. Remember the Gordon Brown Gold Trade?

7) On the massive assumption that the demand side of the equation stays where it is and isn't at all effected by inflation expectations turning from the current mega-deflationary meme, alternative assets become more attractive (he's a bond guy, so probably only knows his universe), Europe de-stresses, or US rates become attractive enough to outweigh the currency risk of holding them instead and finally, someone wakes up and objects to having to pay to give someone else their money.

I rest my case m'lord that your pension fund is under threat.


Ryan said...

Polemic, I fully understand your views on the deflation meme but I am afraid that your logical extension to being short Bunds is incorrect. I have covered this topic on my own website Feel free to contact me directly via the site and we can discuss it further. (Btw - I came across your site via Macro Man; a longstanding friend.)

hipper said...

Pol, very much agree with bunds, especially with the presumption that ultimately fundamentals must prevail, i.e. yields driven through inflation expectations. No one would logically thinking want to be caught pants down in that scenario.

There are of course some arguments for the long side as well, such as banks requiring sufficient quality capital asset holdings and ECB might have to bid pretty far up to find sellers for them to think of changing current positions to something riskier. I don't know much about the asset regulation world though, do you know if there are some changes brewing, e.g. going tighter or laxer?

But I was thinking that if the situation currently could be somehow summarized, it might go somehow like this:

1. US multinational large caps are facing FX and buyback slowdown headwinds with currently already high valuations

2. Broad European bonds with guaranteed negative returns are a no-go zone for other than previously mentioned reasons

3. European indices have already baked in a rather substantial proportion of better short term data,

So then where else is there to go? What do you think on EM credit?

I've been pondering on EM credit and already hold a bit through the large ETF funds, as they still offer yield on the contrary to EZ credit. Also couldn't we think that EZ (and potentially other areas beginning QE programs) will turn into a big supply of liquidity?

Re: better EZ data, if it turns out to be a bit more than just a short blip, then it would be sane to assume it starting to affect inflation expectations and that the trades deriving heavily from deflation theme start winding.

Polemic said...

Ryan thanks so much, I have dropped you a mail to your 'enquiries' address as it was the only one i could see.

I am actually feeling a bit daunted by Ryans comments and knowing him to be a major hitter in macro land has me questioning my simplistic views as I have obviously underestimated the bull case ( proven by prices still going up) especially the bollocks of accounting rules and regs via the banks once again distorting prices. You want an example of enforced stupidity then here is a great one.

But despite that I am hanging in and yes I can sympathises with the ';gets go to EM for yield route but that gets caught up in the same rates circle via higher US rates and a stronger dollar clobbering their own debt loads. Not easy.

Also seeing recent mutual fund allocations pouring into bonds again mixes the picture.

In general i think we are in the silly season final stages of many prices moves but rather than following usual rules both bonds and equities replacing stupid buggers at the same time. HARD.

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