A short squeeze in government bonds?

This summer – when stock markets across the globe began to rally after their post-Brexit collapse, government bond markets put in a top. US 10-year yields bottomed at 1.35% on July 8th. And in the time since, they have zoomed to over 2.5%. In short, while stock markets have rewarded investors, bond investors have taken a beating. What’s happening here?

First, Jamie McGeever over at Reuters posted a chart from Citigroup that is very important. Citi research shows speculators’ aggregate net short position in US Treasuries now at 5 standard deviations above normal – meaning everyone is now on the same side of the trade – short US Treasuries.

With everyone piled into a short position on safe assets, all we need is one crisis trigger to create the mother of all short-covering rallies back into safe assets, not just in the US but globally. Some thoughts below

I think we should interpret the rally in US Treasury yields as indicative of a risk-on trade, especially in light of the rally in high yield and in US shares. The violence of this move higher in yields has caught me by surprise – because I would have thought a relative value position in Australia and New Zealand over stretched yields in the US and the UK – let alone Germany or France – would have been a winner. But New Zealand and Australia have been destroyed with the rest of developed economy government markets.

Hw do we interpret this though? If one is looking for an interpretation of what higher bond yields signal, look no further than the dichotomy between Treasuries and high yield. While the yield on Treasuries has gone up, the yield on high yield has gone down, and the spread has shrunk dramatically.

December 8, 2016 Note that junk spreads have been coming down since February, when the US recession scare ended. So high yield was the harbinger of risk-on for five months. It wasn’t until post-Brexit that US 10-year yields bottomed. They have been on an inexorable uptrend ever since.

And the risk-on trade is evident everywhere you look, not just in the US. This is true across Europe, in Australia and New Zealand and to a lesser extent in Japan. Yields have rallied in all of these places, while shares have also rallied. In Europe, the rally in yields coincided with the end of the Deutsche Bank crisis on September 30th.

Deutsche shares bottomed on September 29th and have rallied over 60% since that time.

Germany’s 10-year shows us that we had a double bottom in Euro yields with the post-Brexit selloff being the first deeper bottom and the Deutsche Bank sell off being the second less deep bottom.

Move out the risk curve in Euroland and yields for Spain’s 10-year are indicative of the rally for government bond yields that is truly risk-off. The bottom there coincides with the rally in Deutsche Bank shares.

So what we are seeing is a rally in risk assets that represents a widespread bet that negative tail risk scenarios are no longer a threat to global growth. Even today, we see Italian bank risk receding in Europe due to the re-capitalization announcement by UniCredit. The bet on growth is so extreme though now, that we are seeing a so-called five standard deviation move toward a net Treasury short position. For me, two standard deviations represents the fat tail portion of any asset price event curve. So five standard deviations means we are well into the extremes – at the 99.999942 percentile of outcomes on a Gaussian curve. Now a lot of this could be a bet on inflation rather than real growth – so we are just talking about an uptick in nominal GDP. Nevertheless, remember that extreme moves are incapable of trending back to the mean without the violent moves consistent with herding.  That sets us up for the mother of all rallies in Treasuries.

Now, there is another take on this to be sure. Jamie McGeever gives us a look at this with a tweet about the downward channel of US government bond yields since 1986.

December 12, 2016 Conceivably, we are about to leave this channel to the upside as a result of the heavy short position. But I would argue that this could take us to the end of the bond bull market as it began between 1980 and 1986 – with heavy NON-CHANNEL volatility. We could very easily leave the yield channel VIOLENTLY to the upside, followed by a violent move back down below the channel.

I, for one, am not at all convinced that long-term global growth is going to accelerate meaningfully. More likely, this is a head fake. And many events could bring yields back down in a hurry.

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