Gavekal Capital: The Modern Day Widow Maker Trade is to Short Treasuries

Thursday, August 28, 2014

The Modern Day Widow Maker Trade is to Short Treasuries

As treasury yields plunge again today to new 1-year lows (the 10 and 30-year treasury bond yields are both down 3bps to 2.33% and 3.07%, respectively), we are reminded of a popular trade over the last decade to short Japanese government bonds, which has aptly been named the "widow maker" trade. The trade seemed to make all the sense in the world with Japanese government dept soaring to new heights which would, as the logic went, inevitably cause the bond vigilantes to wreak their havoc on the JGB market. Instead, bond yields kept falling (from 2% in 2006 to just .49% today) and many a trader was carried out on a stretcher.

Despite most asset managers and economists declaring at the beginning of the year that US treasury yields can't trade lower and will certainly rise in 2014, the exact opposite has happened, and if anything the trend lower in yields is accelerating. Admittedly, there are big differences between the US today and Japan in 2006, but there are also some similarities: low real growth, low inflation, worsening demographics, etc.

Another similarity is the pervasiveness of traders shorting US treasury bonds. The chart below shows the net position in futures and options contracts on 10-year treasury bonds for all non-commercial traders (i.e. the so-called "dumb money") which is the red line on the left axis. The left axis is inverted and negative numbers indicate a net short position. We observe a highly negative correlation with 10-year treasury yields (blue line, right axis) in that the non-commercial traders seem to up their short positions as yields rise, and vice versa, and thus have usually been wrong at major turning points. At the beginning of the year the non-commercial trader net short position in 10-year treasury bonds was as the highest level over the last six years and today that same group is still net short despite the fall in yields. Over the past six years treasury yields haven't stopped falling until the non-commercial traders adopted a net long position, and that level is still far off from here.