The Bogus AAA Sovereign Stupidity Arbitrage

by: Russ Winter

Negative real sovereign yields and now negative nominal yields (NIRP) prevail across the world because central banks are acting as buyers (or funders of buyers) of last resort of sovereign debt. Central banks are synthesizing demand for the so-called highest quality sovereign debt by: 1) outright purchases; 2) giving leveraged banks and hedge funds incentive to own it as one leg of an arbitrage (and in the process create a massive bubble); and 3) withholding credit to competing sovereigns in distress, in turn forcing dedicated sovereign allocators into the (so called) for the moment highest quality debt.

The market signal that low or negative real sovereign yields would ordinarily send is deflationary. However, central bank maneuverings are greatly distorting default-free rates and sending a false signal. Thus, unleveraged investors seeking true preservation of purchasing power are being fooled as to what constitutes safety and risk. Borrowing a term from Max Keiser this can only be called the bogus AAA sovereign stupidity arbitrage.

France is probably the prime example of this. The IMF has debt projections around three scenarios. The top line is the trajectory without any actions by the individual governments. The middle dotted line is what the debt trajectory would look like with mild reforms to entitlements, and the bottom line is the debt trajectory if very draconian measures are taken. With the election of Hollande, France has embarked on the top line trajectory, lowering the retirement age from the current 62 back to 60. Indeed, in all three scenarios, France's trajectory is even worse than Greece. A case could be made in fact that Greece will be forced into the lower trajectory, while France drives off the track with the higher one.

Just like with the US, the rating agencies have maintained France's phony AAA credit rating. As a result the French two year Treasury (and other so called core European sovereigns, see chart) have gotten caught up in the "flight to stupidity arbitrage", and rates have fallen to 0.14%. Netherlands is no safe haven [See Netherlands, Thumb in the Dyke], nor is Belgium.

Contrast this to Italy, which seems more likely to conduct at least moderate reforms, and get its trajectory under control and has a two years yield of 3.95%. This is not to say 3.95% is a bargain, but both France and Italy are exposed to Spain, and have nearly equal potential liabilities to the ECB, EFSF, and ESM's toxic portfolios. But in the Alice in Wonderland world of stupid arbitrage both Germany and especially France get a total pass, so far. The only plausible and dysfunctional explanation is that France's too big to save banks, and by extension France itself, will be saved by what exactly, aliens from outer space?

Nowhere does the stupidity arbitrage get more perverse than in the US. At this point I do not buy the canard that European flows will be the principal driver of Treasury yields. Instead I see the US suffering more and more from its own financial insolvency ranging from municipalities to the Federal level, and that will shatter the US safe haven myth.

The stupidity flight trade is building to a crescendo. Recently, commercial hedgers have gotten aggressively short the 30 year Treasury bond, as well as the two year, five year and Eurodollar. Commercial hedgers have been long 30 yr since 2007, until now. Lee Adler describes huge month end Treasury supply.

My preferred trade to short the 30 years, is the actively traded TBT double inverse. I will post this trade in comments when I execute it. There are active options with about a 30 implied volatility. The tracking on this is good, and this article describes it. The key is not to get caught in a multiple week non-stop run against you, as this compounds. There is also an interest and expense draw-down effect that I calculate at 0.5% a month. With 2.5% a month for the option premium, that leaves 2.0% a month for the writer if expires worthless. I have been tracking TBT and notice a 50 cent move in the underlying for every 10 basis point move in the 30 year yield.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in TBT over the next 72 hours.