R Is For Reverse

It is often said that what goes up must come down. Nothing guarantees that outcome, but it is usually a safe bet. A couple of weeks ago, we discussed the shorts in the treasury market, and the how when yields go up, bond prices go down. I referenced a lot of market players that were effectively ” short ” the treasury market – making a bet that interest rates could and would go higher. I also warned in that same post that it would only take a small grain of sand to turn the tide, and that things could go in the opposite direction.

Today may have been the day when we saw the grain of sand that broke the camels back. Early this morning yields were up across all North American terms. Most of the time we pay attention to the Canadian 5 year yield, and the USD 10 year yield, but all yields were up. The US 10 year yield – the most watched bond in the world was easily above the magical mystical 5.00% mark. It had been bumping up on that level for quite some time, and made a nice breakthrough earlier this morning – around 6 am.

However, just when you think you know what is going on – the financial world has a strange way of proving you wrong. Around 9:45 am, a hedge fund manager by the name of Bill Ackman came on CNBC. Bill Ackman is a very wealthy, very well regarded hedge fund manager that has been making headlines for well over a decade. Mr. Ackman has consistently made bets that seem far out, but somehow always seem to hit. Mr. Ackman has been short US bonds for quite some time. Just so we are clear, he is betting that yields go higher, and bond prices go down. He has been correct, and his wager has paid out somewhere in and around the 1 billion dollar mark to his fund and his investors. We will know more once the quarterly fund results are out, but by all approximations he has made north of a cool billion.

As around 9:45 am EST Mr. Ackman announced – for all the financial world to hear, that he had successfully covered his bond shorts, and was no longer short. He said there was simply too much risk in shorting bonds. At 9:46 the treasury market ( bond market in general terms ) made a very sharp reversal and bond started to shoot up, driving yields to the low of the day. The US 10 year yield went from 5.03% to around 4.81%, before settling around 4.84% at the close. A massive reversal of 22 bps, after clearing the technical hurdle of 5.00% is a massive move. The Canadian 5 year bond made similar moves dropping from an intra day high of 4.30% down to settle around 4.18%.

While some may see it as a flash in the pan, when the ” smart money ” starts moving in a direction, others tend to follow. If some of the wealthiest, smartest, and most connected Wall St hedge funds are starting to cover shorts on Treasury bonds, how long before smaller firms, mutual funds, traders, and momentum traders do the same? How long until the ” short bonds ” crowd is no longer driving the bus, and takes the other side of the trade? No one knows, but history tells us it usually doesn’t take long.

The main concern is that if people like Mr. Ackman are no longer short bonds, and instead start buying, they will drive up the price of bonds ( drive down yields ). The higher bond prices go, the more pain it inflicts on those that are short bonds – making them cover positions. To cover a position you basically have to buy bonds, which further drives the price up, which creates more losses for other holders ( and yourself on the bonds you still own ), and round and round we go.

Bond traders are traditionally highly levered traders, so if they start to lose too much ground on a position – they incur margin calls ,and the lender of the funds starts to sell the position indiscriminately, exacerbating the price up, which, same as above, creates more losses.

We are at a junction where this could lead to a massive amount of volatility in government bonds – and all other types of bonds, and bond proxies. Whether the price action is up or down is irrelevant – it will create a lot of daily fluctuation in yields.

So, what does this mean for brokers? Well, it could mean a couple things:

First and foremost – with volatility in the yields, lenders are going to be slower to change rates on mortgages. With all the up, down, and sideways movements, they will take their time, and only adjust the rates when they feel confident and comfortable they are getting a good return. If we see bond rates come down, expect a bit of a delay in it reflecting in mortgage terms.

Secondly – there has been a lot of volatility in yields as of late, and that will continue, however we have a lot of global unrest, and bonds are usually seen as a safe harbour in a storm. IF, and I say if, but if we start to see the shorts covering their bond positions, AND we start to see natural buying due to geopolitical unrest, rates could come down quickly and fiercely. Of course, they could go back up just as quick once a perceived storm is over, but a lot of the action driving rates up was professional traders betting on higher rates. Now that at least one, and I surmise a lot more traders are taking the other side of the trade, the same momentum that drove rates up, could be the reason they come back down.

I never like to bet against a fellow like Mr. Ackman who has billions of dollars of capital at his disposal, and can move a market in the direction he wants it. If Mr. Ackman is doing this – rest assured the other hedge fund titans are as well. For the last decade or so, you had the US Fed, and the BOC buying bonds to keep rates down, and pension funds and hedge funds buying bonds because they had to. For the last 18 or so months there was no one buying government bonds – it was a buyers strike of sorts. Everyone was selling bonds, and betting on higher rates, at the same time the US Fed and the BOC implemented quantitative tightening and stopped buying bonds altogether, and in fact started selling bonds – a double whammy of sorts.

It was the perfect storm that drove yields on bonds up, and it may be the perfect storm that brings them back down. Time will tell on that, but for now, I would still say that the high yield on the Canadian 5 year has been put in place at the 4.415% it hit back on October 3. That of course doesn’t mean mortgage lenders won’t get greedy, and keep rates high, but it looks like the bond market may be finding its level, and now that the momentum is starting to turn to the side of the buyers, bond prices may catch a lift, and provide a little yield relief to home buyers.

Oh, and in case anyone wants to know, I feel the BOC will hold rates on Wednesday when they meet. We are seeing way too much damage in the economy for the BOC to raise another 25 bps at this meeting – in my sole opinion.