Hey Shorty!!!

What a time to be alive!!! What a time to be a mortgage broker!!! Well, at least one of those is true. In case you were living under a rock the last 24 hours – you may want to go and check out the yield on the 5 year bond. Well the title may be short, the article certainly isn’t.

We are witnessing some incredible volatility on bonds the last 4 to 5 weeks. Lets remember that the Canadian 5 year bond – just 2 short years ago traded at .30%, and now it is increasing 25 bps in one trading session. What has led to the volatility, and what to watch out for now? Lets jump in…

We all know yields are up, and after my last blog, you should know what that does to bond prices ( yield up – bond price down, and yield down and bond price up ). Ok, so what? This is a good chunk of what is leading to a lot of the volatility, and why I think it will continue.

If you are a mortgage broker you ought to know what a hedge fund is. They are very powerful, and have more influence, control, and say in your career than you probably realize. A hedge fund almost broke the back of Home Capital ( Home Trust ) years ago, before being bailed out by Teachers Pension, and Warren Buffet. Hedge funds garner a lot of power and control over companies, banks, and financial intermediaries in today’s tightly knit financial community. So why does this matter to you? Well, a lot of hedge funds suffer from things like group think, dogma, and the like, which means, they tend to act like cattle and all herd together. Also like cattle, a lot of hedge fund people expel the same type of waste as cattle, but that is neither here nor there.

Right now, hedge funds are all piling into one trade – and that trade is short treasury bonds. Before we unpackage that, lets ensure we know what shorting means. This is a pretty complex financial strategy, and I am going to try and break it down so you can have the theory down pat. It is extremely important as to why yields are moving like they are today, so follow along if you can.

In financial markets there is 2 ways to make money – to go long, or go short a stock, security, bond, currency – basically anything that trades. When you go long something , it is pretty easy. You buy a stock for $10.00 a share, and over time you hope it goes to $20.00 a share. You cash out and you have made a $10.00 a share profit. Easy, simple, anyone can do it.

Going short something is a lot harder and more complex. You actually want the price of something to decline to profit. Here is how it works:

If I looked at the shares of ABC company today, and they were trading at $100.00 a share, and I thought they were going to drop to $75.00 a share, I would want to short the stock. They key is to find someone that think the shares of ABC stock is going up to $125.00 a share. Once I found this person – whether it be an individual, company, pension fund, hedge fund – it makes no difference, I strike a deal with them. I agree to sell them shares – say 3 months from now for $90.00 a share. That means that 3 months from now, they will pay me $90.00 a share ,and they think they can sell them for $125.00 a share – and profit $35.00 a share while only outlaying capital for a day, since they will buy them from me in 3 months, and flip them the same day. Now, If I am right, and the stock declines from $100.00 a share down to $75.00 in 3 months time, I go into the market, buy the shares of ABC company at the market for $75.00 a share, and sell them to the person I had the agreement with for $90.00 a share, thereby netting ME a profit of $15.00 a share, on a stock price that went down. That is shorting a market. When you are short a particular security or stock, or anything, you are literally banking on the price declining so you can purchase the item cheaper in the open market, and sell it on a pre arranged sale at a higher price. In mortgage broker terms it is the reverse as the pre con flipping game that has gone on in Canada for years. Imagine if you could buy a pre con house was selling for 1 million today. You assign the contract to a homebuyer to deliver them a built house in 1 years time at $950,000.00. The homebuyers sees it as a discount to today’s price of 1 million, so takes the bait. The home builder builds the house, and in 1 years time it is only worth $800,000.00 market value. You buy it from the builder for $800,000.00 and flip it to your buyer for $950,000.00. Now housing is a lot harder to do, but you get the idea. There will always be people thinking things go up, and always people thinking things go down. A short seller arbitrages out the difference for profit in a declining market.

Ok great – but why do you care? This is where it gets interesting. Right now every major money manager is short bonds. Short to the tune of around 1.5 TRILLION dollars of bets. There is literally 1.5 TRILLION dollars betting that bonds continue to go down ( and that means yields have to go up ). It is the popular move to be short government bonds right now. There is 3 basic problems with this.

First and foremost, if everyone is on one side of the trade, it means there isn’t anyone else to take the other side. If literally everyone thinks the same outcome is likely – no one is willing to take the bet the other way. This tells me that there likely is not a lot of sellers of bonds left, as there is no one that will buy from them to the long side to offset the trade. Much like the Canadian housing market right now – there is a tonne of sellers, and not many buyers, so it is imbalanced. When things get imbalanced, the velocity of trading, and trajectory of trades slows down. This tells me that the days of huge jumps up in yields may be done – at least for now. Now, I didn’t say rates can’t go higher, what I said was that the massive morning jumps and intraday spikes of 20+ bps is likely done for now.

Reason 2 I think we see a bit of a slowdown in increases is due to the function of short selling. Remember the example above with ABC company, when the short seller had to come into the market and buy the shares at $75.00 to deliver them to his buyer at $95? Well, when that trade occurs it is demand to buy, and that starts to lift the price of the stock up, albeit a small amount. However, the devil is in the details. Since all the hedge funds are levered to the hilt to short these bonds, they are extremely sensitive to moves in price. Since you can lever government bonds to about 98%, it means a 2% move in the price against them could wipe out their entire equity in the trade. So, hedge funds are going to be looking for any move up in bond prices, and then you could start to see a wave, or a flood of buying. As soon as the algorithmic trading programs sense price movement, and volume, they start reversing their short exposure, which triggers more buys, which gets higher bond prices, and round and round we go. Let’s remember there is 1.5 TRILLION dollars of exposure, so if only 10% of the short funds start to buy back, you could move bond prices drastically.

Reason 3 should really be called reason 2.1, but it sounds cooler to have 3 reasons than it does to have 2.1 reasons. Data. Over the coming week, and over the next 2 weeks we will have a lot of data in North America, and the EU, and Asia, along with a lot of speeches by Fed Reserve Governors. If the data should change course, or perhaps point away from rising yields ( unemployment spikes, inflation suddenly falls, GDP drops off a cliff ) you could see the market quickly change the ” higher for longer” narrative, and start to think yields have topped. If that happens, and people all of a sudden want to buy bonds at these high yields to preserve the coupon payment for years to come – you could see a stampede into buying bonds. More buyers equals higher prices. This is bad for the shorts as the higher prices start to eat their profits – so they start buying back as fast as they can. Any little thing that Jerome Powell or Tiff Macklem say could erode confidence in higher rates, and start the avalanche. If a geo-political event happened – everyone would rush to the safety of bonds – regardless of economics, and start the stampede. There is literally 20 things that could all of a sudden change the direction of yields.

While I don’t think the volatility is over, the volatility will most likely be to the downside on yields. We live in an ever scarier world where a geo political event is increasing more likely. We have 1.5 TRILLION dollars all shorting the bond market, and the economy is running out of steam. While we could still see yields tick up higher from here, if we were to see extreme moves, my thought is it would be lower not higher.

A very popular ETF that tracks US 20 year government yields runs under the ticker TLT. That ticker logged a high price in January of 2020 of $164.97, and today trades at $85.06. That means that US government bonds have lost around 48% of their value in 3.5 years. This is worse than even the 2008 Great Financial Crisis was for the stock market. Generally when you get any market down by 50%, it bottoms out, and starts to revert back up to the mean. Bonds are oversold – and have been for quite some time. It doesn’t mean they zoom back to the mean, they may choose to meander, they may choose to mosey back, or they may move at a brisk walking pace, but eventually mean reversion is a thing. The opportunity to short bonds was back in 2021 at the low yields, and the opportunity is certainly water down now. Much like buying Toronto rental properties in January of 2022 – you had to have a lot of things go incredibly right to make the trade work – and we all see how that worked out. Bonds, in my opinion, are Toronto rentals in 2022 right now…….