The 'Short Of The Century' May Last Quite A Bit Longer

by: Ivan Martchev

Those in the forecasting business know that markets love to humble them on a regular basis. One such humbling event of late has been the precipitous decline in long-term government bond rates around the globe, handing substantial losses to those who were positioned for a round of rising rates.

The latest inspiration of the dive in global government bond yields has been the decision by the Bank of Japan to experiment with negative short-term interest rates in the wholesale funding markets for Japanese financial institutions - the closest equivalent of which is the fed funds rate.

To demonstrate the ability of markets to humble even the greatest of traders, I penned a piece on May 4, 2015 in Market Mail titled "The Short of the Century May Last A Little Longer," I showed the example of market gurus taking it on the chin with bombastic statements like "the short of the century" for governmental bond markets - like the late and legendary Barton Biggs about Japanese government bonds (JGBs) in 2003, and more recently, in 2015, similar statements about German bunds by dethroned bond king Bill Gross and the newly-appointed bond king Jeffrey Gundlach. While I have the deepest respect for Gundlach, the German deflationary situation was rather precarious and, in my opinion, it was not as big of a lay-up as he was thinking. To refresh your memory, here is what I wrote about that trade last May:

Gundlach's point is simple: If you short a bond that is trading at a negative yield - like the German two-year bunds - you can't really lose: At maturity you are getting paid at par. So if one leverages the trade at 100X on a bund that at the time was yielding -0.20%, one makes 20% at maturity. Sure, he is using wholesale funding markets for leverage that can carry lower interest rates than what a mortal individual investor can get, so his math works. I don't doubt he can make money in the short-term, or even in a year or two, just like Barton Biggs did with JGBs in 2003, but are bunds really the new 'short of the century?'

In institutional markets, as the Gundlach example shows, the leverage can be 100X or higher in some cases so a fraction of a percent yield can be capitalized upon. Such sophisticated trading is not within the reach of the individual investor, nor should it be as 100X leverage is almost an assured road to the poorhouse. One rookie mistake at 100X can wipe out a retail investor.

So what happened to Gundlach's suggested trade since he suggested it in early 2015?

Germany Two Year Schatz Yield Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

German 2-year notes have sunk further into negative territory. So while in theory he is correct and when they mature at par (100 cents on the euro), if he was short German 2-year notes at maturity he was going to make close to 20% if he was leveraged at a rate of 100X. However, if one put on the Gundlach trade with the German 2-year notes at around -0.20% last spring, one would now be losing 29% (at 100X leverage) as those same bonds now yield -0.49%. (To be fair to Gundlach, his 2-year note trade would no longer be a 2-year note trade as those bonds have a constantly falling maturity and now they would be one year and three months away from maturing if he put that trade on when he suggested it in April 2015.)

Be that as it may, my point is to demonstrate how a "no brainer" short-of-the-century trade can turn out to be rather problematic for quite some time before it works out. JGBs had a record low yield of 10 basis points (0.10%) last Friday. One would have lost quite a bit of money if one was shorting JGBs since 2003 as Barton Biggs suggested, although granted, that trade did work for a year or so after he suggested it.

Japan Ten Year Government Bonds Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

How is it possible that JGB yields are at 10 basis points while the Bank of Japan is running a QE program that on a relative basis is three times more aggressive than the Fed's, which in the process has unleashed a tsunami of yen aimed at boosting prices in Japan? (See my May 31, 2013 Marketwatch column, "Repercussions from the Yen Surge.") In 1990, Japan experienced the same type of crash that China is experiencing today: Too much fixed-asset investment driven by ever-rising borrowing hit the wall and domestic consumption never really picked up.

To boot, the banking system had issues for years with credit growth and bad loans. Then, the population began to shrink and age. Older people do not usually spend money as younger people do. So no matter how much the BOJ lowers interest rates and depresses the value of the yen, their deflationary malaise continues.

The Japanese realized that even their ambitious QE operation was not helping as much as they had hoped, so in October the chief cabinet secretary, Yoshihide Suga, encouraged women to "contribute" to the nation by bearing lots of children. He was immediately criticized as he brought back memories of wartime Japan when women were encouraged to reproduce in order to boost the nation's military power. (See October 1, 2015 Telegraph article, "Japan politician tells women to 'contribute' by having more babies.") Despite his critics, the basis of the cabinet secretary's argument is demographically correct, as a shrinking population virtually guarantees that what the BOJ is doing at the moment is only a temporary patch for a much bigger demographic problem. After all, central banks cannot print more babies.

The BOJ monetary machinations raise interesting questions about the yen, which has been acting rather peculiarly in this global deflationary environment. There is no doubt in my mind that the much more aggressive nature of Japan's QE can be called printing, given the different design of the QE program and the outright purchases of stocks by the BOJ as part of it (see my Marketwatch article referenced above).

The U.S. QE program, by comparison, cannot be called printing. I think the U.S. QE is better described as force feeding credit on a financial system that was in the process of deleveraging naturally. The Fed was much more successful compared to the BOJ with a relatively less aggressive QE program (relative to the size of the U.S. economy) due to the lack of demographic problems and a more flexible economic model.

United States Dollar Japanese Yen Exchange Rate - Daily OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

It is not surprising that as the aggressive Japanese QE operation commenced in 2013, the yen sold off from under 80 to over 120 (the USDJPY rate is inverse so a rising chart signifies a weaker yen, or more yen per dollar). It is rather telling that over the past year the decline in the Japanese yen has stalled, even as the BOJ has pressed full QE speed ahead with its printing. This is one of the reasons that forced BOJ's hand in experimenting with negative interest rates last week.

In fact, if one were to look purely at the technicals on this inverse USDJPY chart, it looks like the yen is putting in a rounding top, or possibly a head-and-shoulders top, and the chart may decline further should it break major support at 116, which we tested in January. I believe that the yen is acting counter to the BOJ policies simply because the availability of "carry trades" (where one can use the yen as a funding currency) has greatly diminished and the carry trades that have been put on have had to be unwound, pushing the yen higher! Let's look at an example of a carry trade gone bad.

"Crossover Yen-Vy," or How the Yen Carry Trade Backfired

In a carry trade, a financial institution borrows yen at a tiny interest rate. Only financial institutions can access wholesale yen funding markets so individuals cannot do carry trades - not the kind described here, anyway. Then, the bank sells the yen for Brazilian real (BRL) and buys any other higher interest yielding asset in Brazil to capture the interest rate differential. This is the essence of a carry trade - to borrow in a low-interest-rate currency like the yen and buy assets in a high-yielding currency like the Brazilian real.

Brazil Ten Year Government Bond versus Brazilian Real Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The problem is that the Brazilian real had a really bad year in 2015, down nearly 50%. It is not going to be a very good carry trade if one can get 16% interest in Brazilian government bonds but lose three times that on the exchange rate. The USDBRL exchange rate is shown in the chart but since the USDJPY rate has been relatively stable over the past year the JPYBRL exchange rate has also dramatically weakened. In other words, because of the collapse in commodity prices that is hurting the Brazilian currency, yen-funded carry trades in Brazil have not worked. And this is the case for many other commodity currencies as well.

This is why we are in the absurd situation of seeing a stable yen when the BOJ is printing in a manner that may make Japan look more like Easter Island. It will be even more absurd if the yen appreciates past 116 per dollar with negative interest rates in Japan and commodity prices falling further courtesy of the Chinese economic unravelling. Regrettably, I believe this is quite possible.

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