The "Home Run" Bond Trade Is Setting Up

08/20/2010 12:01 am EST

Focus: COMMODITIES

Andy Waldock

Founder, Commodity & Derivative Advisors

Japan’s official interest rate policy hasn’t been above 2% since 1993. In fact, since 1996, it hasn’t been over .5% and has bounced along at zero for much of that time. Furthermore, Japan has actively increased its balance sheet through the direct purchase of corporate debt as well as absorbing numerous bad loans. In spite of this historically loose monetary policy, Japan’s major fight for over a decade has been deflation. Our own Federal Reserve Board’s decision on August 10 to leave rates steady and purchase long-term notes is a strong push towards zero interest rates here in our own country and is a clear statement that the major concern here is also deflation.

When we view the recent actions by our own Federal Reserve Board within a global context, we see the following picture emerge: Global deflation. The largest economies in the world, the US, Japan, England, Germany, Spain, France, etc., are all in recession and facing debt crises. In fact, the G7 as a whole is currently carrying a debt-to-gross-domestic-product ratio upwards of 110%. This means that the seven largest free economies currently are borrowing 10% more than they produce in a given year. How long could any of us run our houses or businesses like that?

China, while not in recession, is slamming on the growth brakes in an attempt to prolong their prosperity and avoid the boom-and-bust cycle. The combined global action is an attempt to borrow our way out of debt. The simple version is that governments lend money to be put to work creating jobs, goods, and services in anticipation that each job, good, or service will generate revenue in excess of the principal plus interest loaned. However, the money being loaned is not being put into the creation of infrastructure or small businesses, both of which would have lasting payoffs.

Thanks for bearing with me through the setup of the macroeconomic trade that’s taking place.

Commodities as a whole have risen throughout the period of loose fiscal policy with gold and silver leading the way. The more money the global governments pump into the system, the more people want to place their inevitable inflation trades. These fall into three categories: Buying metals, selling interest rates, and selling the US dollar. The emotion attached to these trades is the “home run trade.” Talk to your buddies; I’m sure that one third of them fall into this category. Listen for phrases like, “The dollar is worthless;” “Gold is going to $5,000 an ounce and I’m going to catch it all;” and finally, “Stay away from bonds. These historically low rates can’t last forever with all the money we’re printing.”

It’s been my experience in trading that the day-to-day task of trading the markets profitably has never been about catching a generational shift in market behavior. Making money in the markets on a consistent basis requires following the major players and the moves they create. This requires the ability to set aside personal feelings of any given market and fall in line with those who are collectively smarter than we are.

The most dynamic setup is in the interest rate complex. People have been reluctant to buy bonds since late 2007. The operating thesis was that the government is going to flood the system with liquidity, which can only lead to inflation. In normal times, I would agree with that statement, and so would the markets. However, after a brief dive in June 2007, bond prices have increased by 50% while yields are correspondingly lower. At these prices, most of the calls I get are from people either afraid to buy bonds, or people who can’t wait to sell them.

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Currently, the yield to maturity on long bond futures is around 3.375%. This equals a long bond futures price around 133. The long bond had been consolidating for nearly a year as investors expected the yield curve to steepen as the recovery got underway. The general action in the market was to buy short-term debt and sell long term. However, as the recovery has failed to find its legs and the global governments prepare for a lengthy slowdown, we’ve seen a substantial build in commercial traders’ acquisition of long -term debt. As much as people dislike the idea of 3.375% interest rates, there is the opportunity to gain some price appreciation in the interest rate complex.

(As I’m proofreading this, Professor Jeremy Siegel of the Wharton School of Economics is on CNBC arguing that the current yield on government bonds do not represent a good investment for most portfolios. My argument is for price appreciation in the futures market, not yield accrual in the cash market.)

The scenario is this. The 30-year T-bond futures have a margin requirement of $3,375. The contract is a 6% coupon with a face value of $100,000. This market is currently trading at a price of 133 with a 3.375% yield. The consensus is that the bond market will continue to climb in price, which means lower and lower yields ahead. We stated earlier that Japan has gone through deflation and their government operated at 0% interest for years. In spite of the governments 0% stimulation plan, Japanese government bonds never traded below a yield of .5%. If we are to assume that our situation is going to take longer to sort itself out than we first expected, then it is safe to say that we will edge closer to the 0% rate that our Federal Reserve Board is already defending. If 30-year T-bond futures were to drop to 2% yield to maturity, that equals a futures price of 165.59, or approximately a $30,000 gain on the contract’s $100,000 face value. A futures price of 190.03, which corresponds to a 1% yield to maturity, would equal a gain of $57,000 per contract. Finally, to match the Japanese government bond’s all-time low yield of .5%, 30-year T-bond futures would have to trade, in price, up to 204.53. This would equal a cash gain of approximately $90,000 on the $100,000 face value.

Bonds should remain a part of one’s portfolio. Through the use of the 30-year bond futures, the market’s price gain can be captured as yields continue to fall without having to commit a large portion of available cash. The $3,375 initial margin requirement to control $100,000 face value Treasury bond contract helps illustrate the beauty of the commodity markets. Since it is extremely rare for a trader to be instantly right about the markets, a sufficient cash cushion should be kept to absorb day-to-day price fluctuations.

By Andy Waldock of Commodity and Derivative Advisors

Andy Waldock is a trader, analyst, broker and asset manager and may have positions for himself, his family, or, his clients in any market discussed. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

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