Macro Trends/Forecasts

Jeff Miller

"The Man Who Called Dow 20,000" --CNBC

The Potential Effect of Interest Rate Arbitrage

This post will describe the current trade depressing yields in the long end of the US Treasury market, particularly the ten-year note.

Who is doing the trade?

The trade is possible for anyone who has an account that permits one to sell short European fixed income securities.  It is also possible via a negotiated swap contract with a counterparty (who probably hedges their own exposure).

How can we tell?

My FATRADER colleague, Eric, says that he would like to see data supporting this.  I also love data, but these trades are not reported.  Here are the reasons we know that the trade is on, and probably in size.

  1. It is available and profitable, especially for those who can use leverage.  If there is an edge, hedge funds will do it.
  2. Traders tell you – especially those who have to trade against the hedge.
  3. The concept has been public for years and widely recommended.
  4. The ten-year note does not reflect much change in growth expectations.
  5. You see the effects in the Treasury market but not in the muni market.

Background – Long-Term Capital Management

An effective and interesting way to understand this trade is to revisit the story of Long-Term Capital Management.  This fund, founded by Nobel Prize winners and leading quants, started by using highly levered arbitrage trades using different instruments in the same security.  A common example used original ten-year notes that now had differing times to expiration. The most commonly traded note had a liquidity premium.   You could by the others and see the more expensive one.  Eventually, as Myron Scholes said, “There was a date with destiny.”  The two had to converge.

LTCM was successful for several years and attracted many investors.  AUM reached nearly $5 billion.  Their leverage was 25-1, so the value of assets and liabilities on the trade were in the $125 billion range. There were also many copycats.  The basic strategy was no secret, but the actual trades were secret.  The Wikipedia entry is a good starting point.  Everyone should know the story.  Roger Lowenstein’s When Genius Failed is an excellent and complete account.

The collapse of the fund occurred when the Asian and Russian financial crises hit those bond markets.  Keeping the story simple, the fund’s long positions were in these high interest markets – the ones losing value.  The fund’s short positions were in US Treasuries, which were rallying as part of a flight to quality. Margin calls ensued, and trades were liquidated at unfavorable prices.  Eventually, the entire fund required a bailout, which did not save the original investors.

The Current Carry Trade

The concept of the current trade is similar to the LTCM approach, but in this case the US Treasury is not the “funding currency.”  Bill Gross explained it more than two years ago.

For those who are not able to sell short the German bund, you can enter into a swap spread.  The three most important risks are the following:

  1. Adverse exchange rate moves, e.g., the dollar falling against the Euro.  This risk can be inexpensively hedged with a paired futures trade or a currency swap.
  2. An decrease in Bund rates (implying higher prices for your short position).
  3. An increase in Treasury rates, implying lower prices for your long position).

The Implications

Crowded trades seem just fine – until they are not.  No one knew the extent of the LTCM trade, including copycats.  No one knew the size of the subprime derivative market.  And no one knows the scope of the current carry trade.

Leverage gets high, since the best prices (and highest profits) are available to those who can draw upon friendly lenders.  There is a buffer against things going wrong.  If the prices start to go against you, then the trade is actually more attractive for new players.

I cannot know for sure what might happen, and I don’t regard doomsday predictions as very useful.  I’ll keep this simple and modest.  If U.S. interest rates start to move higher, without a corresponding move in Europe, a squeeze may ensue.  Some hedge funds will blow up. The forced unwinds will exacerbate the original move, increasing the pressure. The same could happen if European rates move lower while the U.S. stays the same.

And if anyone failed to hedge, or did so inadequately, the effect would be much worse.  And finally, current yield curve signals are significantly influenced by this trade.  Skeptics should try to explain why we are not seeing a similar effect in the muni market.

Jeff Miller provides Economic Analysis as well as Market Forecasts as one of the original contributing analysts at FATRADER. A quantitative modeling expert and former university professor who is the #1 Economics contributor at Seeking Alpha, Jeff is regarded as an expert on economics, market reaction to news events, and computer-based trading.
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