A Mystery in 10-Year Treasuries Has Links to Carry Trade Blowup

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16 April 2021

Video commentary for April 15th 2021

 

Eoin Treacy’s view

A link to today’s video commentary is posted in the Subscriber’s Area. 

Some of the topics discussed include: commonality between sovereign bond futures, gold and growth stocks, global supply chain snarls + geopolitics favour Taiwan, Mexico and India, oil steady, commodity currencies firming. 

 

A Mystery in 10-Year Treasuries Has Links to Carry Trade Blowup

This article by Stephen Spratt for Bloomberg may be of interest to subscribers. Here is a section:

Hedge funds are snapping up 10-year Treasury futures, and no other maturity, presenting a puzzle. The answer may lie in the collapse of a popular carry trade last year.

The highly-leveraged basis trade involved going long cash bonds and selling futures, to profit from the difference between the two, but came asunder in March 2020 when investors stampeded to buy the latter at the peak of coronavirus fears and upended the spread. Now the gap — the so-called gross basis — has reversed and favors shorting cash bonds and buying futures.

Of course, it’s not quite that simple. In futures markets, the counterparty who is short determines which specific cash bond traders have to deliver, adding another element of risk to the transaction. But with so-called ultra 10-year Treasury futures, there are only two bonds in the delivery pool, limiting that risk compared to other contracts.

That could be one reason why leveraged funds have built up net-long positions of almost 230,000 ultra 10-year futures, despite this year’s Treasury market slump, according to the latest data from the Commodity Futures Trading Commission. As for the original strategy — there are no signs of it returning anytime soon.

While returns from this year’s trade are much lighter, a play based on 10-year ultra futures is most attractive, according to one trader who asked not to be identified as he isn’t authorized to speak publicly.

Cash Bond Pressure
A sense of how the cheapest-to-deliver 10-year Treasury bond has performed against futures can be seen in the implied repurchase rate for the note. It flipped from positive to negative in the first quarter, indicative of greater selling pressure on cash bonds than futures.

“With the sudden and significant rates selloff in late February, Treasuries came under pressure, underperforming futures quite noticeably,” wrote Morgan Stanley’s Kelcie Gerson in a note this week. “On an outright level, futures/cheapest-to-deliver bases reached the widest levels seen since last March/April.”

Across the rest of the Treasuries curve, hedge funds hold net short positions, though well below last year’s levels after the collapse of the original basis trade.

Market
A gauge of aggregate leveraged fund short futures positions — which would likely be mirrored by long cash bonds in a basis trade — has dropped by over $300 billion since last year’s February peak, according to calculations by Bloomberg.

 

Eoin Treacy’s view

Repositioning in the sovereign bond markets gathered pace today with a high degree of commonality across the sector. This above narrative highlights how quickly positions can be unwound when the trend changes and it represents a potent source of short covering activity.

 

JAPAN VALUE An Island of Potential in a Sea of Expensive Assets

Thanks to a subscriber for this report from GMO which may be of interest to subscribers. Here is a section:

Successful cost cutting, rising profits and free cash flows, and a corporate culture of risk aversion stemming from the bursting of the Japanese bubble led to an ironic side effect: over-capitalized balance sheets. As Exhibit 4 indicates, over 50% of listed nonfinancial companies are “net cash” today.3 In the U.S., that figure is less than 15%.

Carrying large amounts of cash, especially in a negative interest rate environment like today, is troublesome for shareholders. Equity investors expect companies either to reinvest surplus capital in projects that generate returns above the cost of capital or return it to shareholders so they can reallocate to value-creating investments.

These “lazy” balance sheets have drawn the attention of Japanese regulators and government, two groups that are trying desperately to spark economic growth to help address the pension burden in a country with a declining population and negative yield on government bonds. Furthermore, the Japanese equity market is filled with inefficiencies that offer upside opportunities for patient investors. The number of analysts and investors covering the Japanese market has declined following decades of disappointing returns after the bursting of the 1980s Japanese bubble. Cultural and language differences also have diminished foreign investor interest in Japanese equities.

 

Eoin Treacy’s view

A couple of years ago Mrs. Treacy was looking for a factory to can Akoya pearl oysters in Japan. There are a small number of companies in the prefecture around Kobe that perform the service but we ran into a recurring problem. They did not have available capacity and would not consider taking on additional customers. The feedback we received was universal, they did not want new customers. 

 

S. Africa Central Bank Governor Sees Room to Keep Rates Low

This article from Bloomberg may be of interest to subscribers. Here is a section:  

South Africa’s central bank is likely to maintain its accommodative monetary policy stance to support the economy for as long as it has room to do so, according to Governor Lesetja Kganyago.

“As long as inflation is remaining contained, the central bank would have no reason to remove the accommodation that we are currently providing,” Kganyago said Thursday in an interview with Bloomberg TV.

The monetary policy committee has cut the benchmark interest rate by three percentage points since the start of 2020, of which 275 basis points of easing was in response to the impact of Covid-19 on the economy. That’s taken the rate to a record-low 3.5%. Last month’s decision was the first time since the 2020 rate cuts in which no member voted for a reduction and expectations have now shifted to when the first hike will come.

While the implied policy rate of the central bank’s quarterly projection model, which the MPC uses as a guide, indicates two rate increases this year of 25 basis points each — next month and in the fourth quarter — policy makers see risks to the inflation outlook as balanced and feel that they can continue to offer support to the economy, Kganyago said.

 

Eoin Treacy’s view

South African government bonds yield 9.08%. Obviously, in a world of ultra-low rates that outlier must exist for a reason. South African growth is expected to be in the order of 3% this year but the big question for investors will be on the trajectory of governance and the speed at which the pandemic can be overcome.

 

Eoin’s personal portfolio: futures long opened March 30th

Eoin Treacy’s view

One of the most commonly asked questions by subscribers is how to find details of my open traders. To make it easier I will simply repost the latest summary daily until there is a change.

 

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