May 31st, 2014
by EconMatters, EconMatters.com
Filling in the Details
So the High Yield Carry Trade is what has brought the 10-Year down to the 2.62% area, Hedge Funds started realizing what was going on in the Bond market, and started getting involved when yields were around 2.8%, but they are just jumping on the tails of the High Yield crowd with the size required to move this market 50 basis points.
Once we settled into the 2.62% area hedge funds made a run for the 2.58% area lows, then covered and we were back up around 2.65% yield. From there European Bonds started rallying in price, going down in yield on the belief that Mario Draghi was going to do some kind of stimulus program involving bond buying, investors wanted to front run this event, this led US Bonds to also rally in price and go down in yield which is the move down to 2.47%, then the traders covered and we retraced back to the 2.56% area yield.
Read More: Fed To Raise Rates in 9 Months
From there traders waited until the econ news came out on Tuesday where yields rallied, and then with no econ data to worry about made the next push down to the 2.43% area on Wednesday in a relatively light volume trading environment. This is straight out of the trend trading handbook, and traders have yet to cover this latest push down hoping for additional profit with protective stops in place.
Make no mistake this is just a trade for these folks with no long-term conviction regarding where bond yields should trade relative to the economic fundamentals. These same traders will be pushing in the other direction in a couple of months; this is how momentum trading works these days.
Market Moving Events Next Week
There is economic data on Thursday with GDP revisions and Jobless Claims numbers, but relatively speaking, next week is where the rubber meets the road on this trade. Hedge Funds are piling into this trade trying to push some technical areas in a light volume week, see where yields end up next Friday for any commitment to this trade by Hedge Funds.
Read More: May's Employment Report To Top 300k
My guess is that there is major covering or closing out of positions by the end of next week similarly to how the Hedge Funds all ran out of the Natural Gas trade, sending NG Futures down two bucks in two days as nobody wanted to take delivery of said natural gas in their largely paper world.
Lots of Stops Protecting Profits
Therefore, to sum up the High Yield chasing environment fueled via Low Interest Rates for Borrowing are the reason all rates are this low, but this last move down in bond yields has been due to front-running the ECB decision on June 5th, and hedge funds piling in as they always doing smelling blood in a hot market for technical damage.
As an aside, these aren't high yields all things considered, but high relative to essentially zero percent borrowing costs once you factor in the kind of leverage being used in this trading strategy.
It might be worth pointing out that the bond market is tightening like a coiled spring and can explode higher in yields an easy 20 basis points at the drop of a hat, look for the ECB Meeting or the US Employment Report to be a potential catalyst next week!
Questions – Low Yields
We occasionally turn the volume up on the TV's just to hear what others are thinking in mainstream business media with the Sales & Name Game that is business television these days and CNBC asked the following question: “Why if everybody is talking about inflation is the bond market not moving?”
Frankly, there is so much market illiteracy even among the professionals in the financial market as witnessed by the conversation revolving around high frequency trading, even by the so-called experts who commented publicly on the issue it should be expected that many market participants fail to understand the bond market dynamics regarding why yields are so low relative to expectations at the beginning of the year.
So here goes:
- Bond yields rallied to the close of 2013, and they were at very elevated levels.
- Equities were also at all-time highs.
- The first quarter was tough for two reasons weather, and an exceptionally front loaded 3rd and 4th quarters that left slack in the inventory and spending cycle.
- Lots of low interest money available from many fronts, see Japan, China, US and Europe.
- Makes sense given the cheap money available, yields at relative trend range highs, equities range bound, and economic data suffering because of an extremely debilitating winter and Growth Pull from Robust 3rd & 4th quarters, to put on massive yield chasing conservative carry trades. These were conservative given the aforementioned unique set of points coming together just right.
Read More: Hot Inflation Reports To Dominate Fed Next Meeting
The High Yield Carry Trade Explained
Here is the trade borrow at rates from 10 to 25 basis points, and I mean borrow in exceptionally large terms (leverage), then depending upon the currency one borrowed in (there may be currency machinations involved in getting into the currency where wanting to invest this cheap loan, i.e., sell Yen and buy Dollars), then pick a ‘perceived’ low volatility asset that pays some form of Yield, i.e., 10-Year at 3%, Utility Stocks with High Yields, etc. buy this yielding asset and sit back and rake in the delta each day, week and month!
Read More - Bond Market: U.S. Is Not Japan or Europe
It is important to remember these key points regarding this trade
- Low volatility instruments;
- Exceptionally Low Short-term Borrowing Rates;
- Leverage, Leverage, and more Leverage. This is why Gold has been out of favor the last couple of years because it pays no Yield! When in doubt follow the money trail, and there has been a huge amount of money made by utilizing this trade setup.
Another requirement has to do with the market going in the direction that these investors put their vast leverage to work (or at least stays within a defined range that investors are comfortable with before losing more principal than they earn in interest carry, i.e., utility stocks going higher or bond prices going higher with yields lower). Also depending upon the currency borrowed in a Positive Carry enhances the trade and an extremely negative carry negates this trade altogether in many cases. Google this if interested but not the scope of this piece.
Read More - Coal: A 'Million Dollar Mile' Getting Longer In the U.S.
Big Banks Love Leverage Yield Plays
Many investors have put this trade on and off over the last five years of QE, and recently the Big Banks have been buying up a bunch of the treasuries that the Fed is no longer buying from the start of 2014 going forward.
I imagine this is a way to offset other areas like mortgage refinancing where they were struggling with rising rates, and everybody already effectively refinanced. The Big banks are always looking to make money and this trade sure has helped their bottom line the first two quarters of 2014.
I might also add that bonds are seasonal in nature, and many hide in bonds during the sell in May Summer doldrums. But make no mistake the reason yields are so low right now is because there is money to be made from such a market dynamic.
Carry trades are very popular in the history of modern finance and Big Banking, and the use of massive leverage is their go to strategy where they lack creative talent who can confer a competitive market advantage – Big Banks have no talent! This is an oversimplification but anybody who is really talented can make so much more money working in other places, compensation is off the charts in some cases.
Thus to sum up the Carry Yield Trade is the main driver of why Bond Yields are so low and utility and other high yielding stocks are so high. This trade works until it doesn’t, and it is my guess that many Big Banks figure they have the entire second quarter before they need to start unwinding this trade.
I think they have much less time, and are pushing this trade trying to pick up pennies in front of a massive steamroller of inflation coming down the road. I think the writing on the wall may be as soon as 6 more trading days and the ADP Employment Report, I sure wouldn't want to own a bunch of treasuries going into next Friday's Employment Report or the Fed Meeting in a couple of weeks!
But at any rate, once the Fed starts to raise rates and usually they are forced to by rising inflation (they never do it until their hand is forced) all the sudden the cheap money dries up, but long before that happens investors all start to unwind the trade, other investors pile on in the direction of the unwind, and this is where the steamroller analogy comes into play.
As massive unwinds the size required to make this kind of trading strategy work are really hairy, and oftentimes cause more losses than the money made in the prior two quarters making money on this trade by the Big Banks. However everything is quarterly results oriented and being on bonus track on a daily basis at some firms so long range foresight is often lacking in trade configurations. Did I mention a lack of creative talent at the Big Banks who often substitute brut size and scale to make money in the markets as their best investment strategy?
Economy is Picking up Pace
So the High Yield Carry Trade is why Bond yields are where they currently reside, and is this saying anything structural regarding the economy? No! Will these low yields persist through year end? Again No! And remember when in doubt follow the money, and high yield chasing earns a lot of pennies until it gets steamrolled!