A Fresh Harvest of Widows in the Widowmaker Trade | Monetary Realism

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A Fresh Harvest of Widows in the Widowmaker Trade

There is a famous trade out there called "The Widowmaker". Here is Joe W of Business Insider describing the trade:

"In finance, the "Widowmaker" trade basically means one thing: Shorting Japanese Government Bonds (JGB) and inevitably losing money.

Because of Japan's gigantic national debt, and because the Japanese bond rally has gone on so long, investors have called the top in the Japanese bond market for years, only to get impaled"

This has been going on for over 20 years now, and yet people have been crushed by the trade over and over again.

People are starting to think the government bonds in the United States should be shorted – because the U.S. has run up too much debt, and is engaged in "unlimited" QE. I put "unlimited" in quotes because in this case "unlimited" means "about as much as we did the last few times". But the overall structure of the thinking is nearly exactly the same as how people have been thinking about Japan for the last 20 years.

The widowmaker trade works with a few easy to spot steps:

1. Lots of people convince themselves inflation is right around the corner
2. They sell government bonds in huge quantities
3. They lose a ton of money when they are wrong about inflation

If you want to trade bonds while QE is going on, you need to think like a bond vigilante during QE, and then do the opposite once QE ends.

During QE, it is foolish to fight the massive tsunami of bond selling pressure. The CME is setting record volumes in their futures contracts, which is mostly due to the amount of volume in the interest rate complex.

Here is a quote from that post (bold mine):

"One interesting development in the U.S. Treasury and related interest rate markets is the soaring volume of transactions as all types of market participants position themselves for a life without the Federal Reserve as a guaranteed buyer."

Hmm. We will come back to this idea a bit later.

And of course, the real world data seems to support this idea.

Recently Izabella Kaminska is running a bit of a victory lap because she is finally getting well-deserved recognition she was one of the first on the "QE causes deflation" bandwagon.

People starting to realise QE was actually becoming a deflationary force? m.europe.wsj.com/articles/a/SB1…

— Izabella Kaminska (@izakaminska) May 31, 2013

 

This is a long time after she pointed out it was likely QE would cause deflation rather than inflation in this great post at FT alphaville.

The traditional thinking on QE is that it causes massive inflation. That QE is money printing of the most despicable method. That a bit of QE will cause massive hyperinflation.

Yet, we are well into our third round of QE here in the United States and inflation is subdued.

Still, this post is about the fresh harvest of widows that is about to be reaped in the widowmaker trade. One of the other ways to think about QE is through my soon-to-become-famous cash for clunkers QE bond trading model. Here is the description from when I called the top of bond yields right before QE II ended:

"I am starting to think that QEII does the same thing with Treasury debt. It pushes potential sales of Treasuries forward into the actual period of QEII.If you were looking to sell $50bn of Treasury bonds in August, wouldn't you at least consider moving the sale forward a few months, and selling those bonds in May or June?  Who wants to sell during one of the all time great bond selloffs?The U.S. Federal Reserve has stated they would buy truckloads of bonds during QE II.  So you know you can go into the market and sell, sell, sell – without any real impact on market prices.And if you're considering selling Treasuries in May, why not sell them today?  QEII might be suspended…and who wants to sell during one of the all time great bond selloffs? Why not sell them before that happens?

I think that every asset allocator in the world who is even considering selling Treasuries this year will do it earlier rather than during one of the great all time bond sell offs.

It's cash for clunkers argument applied to Treasuries.  It turns out that the critics of Cash for clunkers were correct – car sales did slow after CfC ended.   Basically, it pulled a bunch of car sales out of the future and into the time frame of the Cash for clunkers program.

The Fed's QEII is a great opportunity for weakly committed holders of Treasuries to exit their positions.  There is a known huge buyer of Treasuries in the market – why not sell to that known huge buyer?

I suspect this same thinking has something to do with the huge rally that happened at the end of QE I as well.  If you recall, there was nearly universal bearishness for the post-QE I bond market, but the day it stopped, bonds went on a historic rally.  All of the sellers had already sold when they knew the Fed would be there – so only natural buyers were left in the market.

 So we have a cash for clunkers effect, because people prepare for life without a guaranteed buyer.

Here is Barry Ritholtz saying the same thing.

"1) Large bond portfolios (think PIMCO, DoubleLine, etc). are getting out of the way in advance of Fed tapering. You can debate if they are early or not, but it is what it is.2) Watch the impact this has on credit driven purchases: House (especially) but also Autos and CapEx."

This mentality isn't hard to find at all.  It's really common belief in the markets "boy, if yields are going up today, wait until you see whats going to happen when the fed stops buying!"

If QE causes real world deflation, while people thing (incorrectly) QE causes inflation, then you'd expect something like a huge rally in bonds once QE ends, and then this rally to continue as it becomes obvious from real world data QE is causing deflation instead of the expected inflation. Combine this with a desert of sellers (who already sold when the fed was buying), and you have the recipe for huge, huge bond rallies once QE ends.

We know Japan engaged in QE on several occasions during the last 20 years. I don't have a good timeline that lines up japanese policy and yield movements, but we do have the legend of the widowmaker. Anyone thinking yields will continue to go up once QE ends (or is tapered off) is almost certainly going to be part of the next harvest in the widow maker trade.

 

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