That 'Short Of The Century' Is Still Not Working Out

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Includes: BNO, DBO, DFVL, DFVS, DNO, DTO, DTYL, DTYS, DWT, GGOV, GSY, HYDD, IEF, IEI, ITE, OIL, OILK, OILX, OLEM, OLO, PST, SCHR, SCO, SZO, TBX, TBZ, TYD, TYNS, TYO, UCO, USL, USO, UST, UWT, VGIT
by: Ivan Martchev

On May 2, 2015, Randall Forsyth of Barron’s penned a piece in his Up and Down Wall Street column (“German Bunds: The Short of the Century”) in which the veteran financial journalist discussed some famous bond traders who were making comments about German government bonds, known as bunds.

Here are two notable paragraphs from Forsyth’s column currently under discussion:

The bizarro state of affairs has been much discussed here and elsewhere. In recent days, this weirdness has spurred the once and current Bond Kings to suggest that negative interest rates not only are unsustainable, but also tradeable as short sales. Bill Gross, the former head of Pimco before exiting for Janus Capital, called betting against Bunds the short ‘of a lifetime,’ while his rival, Jeffrey Gundlach, who heads DoubleLine Capital, similarly termed it the short ‘of the century’ that’s just 15 years old.

As Gundlach expounded in a Bloomberg television interview, shorting two-year Bunds that yield minus 0.2%, and leveraging that position 100 times—not unheard of with relatively short-term, high-grade debt instruments—should return 20%. It’s a mathematical certainty that the bond will lose value by the time it matures at par in two years, resulting in that leveraged return.

While I opined on several occasions at the time that bunds were no short of the century, I was reminded of those proclamations two months short of their two year anniversary when the German two-year note yield, dubbed as” the Schatz yield” (Schatz = Treasury), fell to an all-time low of -0.96% last Friday!

Germany Two Year Schatz Yield Chart

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

If that two-year Schatz was a no brainer to short at -0.20%, it must be a quintuple no brainer to short at -0.96%, as the yield is almost five times deeper in negative territory today, right? The thing about such dramatic phrases like “the short of the century” or “the short of a lifetime” is that they imply some sort of urgency to do the trade, which was obviously not the case two years ago. If it hasn’t worked out in two years, it would suffice to say that this was no short of the century.

To be fair to Mr. Gundlach, if he had shorted German two-year notes at -0.20% and met the margin calls on that 100X leverage, he would have actually made money as all bonds mature at par. The two-year notes he may have shorted in 2015 would have been one-year notes in 2016 and would be maturing in May 2017. Let’s hope he does not short the German two-year note approaching -1% as political risk is simply difficult-to-quantify at the moment in Europe. I think the impending Brexit and the threat of a Frexit, pending the outcome of the French presidential election, have a lot to do with this action in German bunds now.

Germany Government Ten Year Bond Chart

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

While Mr. Gundlach was referring to German two-year notes at the time, Mr. Gross was referring to 10-year bunds. Yes, they did turn from 5 basis points in yield all the way to 1% in mid-2015 after he made his “short-of-a-lifetime” comments, but later they turned negative with persistent pressure on the bund yield ever since. Bund yields rebounded after the U.S. election but look to be headed again for negative territory as the election cycles in France, the Netherlands, and Germany promise much drama in the months ahead. In fact, I think it is likely that both the two-year and 10-year bund yields will end up in negative territory at the same time. When that happens two-year bunds, or bundesschatzanweisungen as they are called in Germany, will likely be much deeper in negative territory than 10-year bunds. Then, the Germans will actually have a positive yield curve (as when you deduct a bigger negative number from a smaller negative number you get a positive difference).

United States Government Ten Year Bond Chart

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

All this drama in German bunds due to the political uncertainty in Europe is also beginning to be felt in the U.S. Treasury market where 10-year yields closed at 2.3117% last Friday. Keep in mind that there is talk that the Fed is “behind the curve” and that we may have to have more rate hikes in 2017 to catch up with inflation. There is also talk that a rate increase is “on the table” in March, yet Treasuries are rallying?

I think the Treasury market will continue to appreciate as the French election draws near. The EU cannot survive a Frexit, even though it may be able to survive a Brexit, although in a weakened condition. But since there are also elections in the Netherlands and Germany this year, this makes it very problematic for the Fed to undertake an aggressive rate-hiking cycle.

I also think that the chances are better than 50-50 for the 10-year Treasury to drop below 1% before President Trump’s first term in office ends in January 2021. I know President Trump has a very ambitious agenda of deregulation and tax reform, but we have never had an economic expansion longer than 10 years in this country (March 1991 to March 2001) and I cannot see how the Trump administration will be able to beat that record. The present U.S. economic expansion will be eight years old in June 2017, which at that point would become the third longest recovery in history.

I think bonds in the U.S., or Germany for that matter, are not quite the “short of a lifetime” yet.

The Missing Down Leg in Crude Oil

I thought we had a better-than-even chance to have another dramatic winter in the crude oil markets – similar to what we saw in 2015-2016 – because inventories were high and production was not all that low.

I was wrong.

Crude Oil Chart

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

The key has been the November 30, 2016 OPEC deal to cut production, which has stabilized the price of crude oil. At the time, OPEC decided to cut production in 2017 by about 4.5%, or 1.2 million barrels a day, which was the first cut in eight years. Even the Russians agreed to participate, cutting production by 300,000 barrels per day.

This is where the plot thickens, as they say in the movie business.

U.S. crude oil production is reported with a lag, so in February we got the November data, reflecting a sharp uptick. Crude oil production in the U.S. increased to 8.904 million barrels per day in November, up from 8.807 million barrels per day in October. Crude oil production in the U.S. hit its all-time high of 10.044 million barrels per day in November 1970 – a level that was largely assumed to be impossible to reach again, but we more than doubled production from a record low of 3.983 million barrels per day in September 2008 and were likely headed for a new all-time high if it had not been for the price downturn.

United States Crude Oil Production Chart

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

With the massive amounts of money borrowed to develop high-cost shale production, the incentive to create a sharply rising rig count is here to stay. I think both production in the U.S. and rig counts will rise sharply in 2017. While that won’t likely be enough to cover the OPEC cut, it will be substantial.

United States Oil Rig Count Chart

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

But all those are supply considerations. We may also have a drop-off in demand depending on some pending economic developments in Europe and China, so we are not completely out of the woods yet.

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