The Bond King Gets Desperate

June 16, 2011
By

Bill Gross (aka the bond king) is starting to get a little desperate.

Three months ago we asked, Did PIMCO call a bottom in Treasuries?

Since then USTs have gone up — and yields have fallen substantially.

This made the bond king look bad — especially when it came out that PIMCO had a net short position (later clarified to be via swaps).

Either way, though, Gross has been pounding the table for how lousy Treasuries are.

As USTs went up, seemingly mocking the king, he pounded the table even harder. This week, he really started stretching it.

Via CNBC:

When adding in all of the money owed to cover future liabilities in entitlement programs the US is actually in worse financial shape than Greece and other debt-laden European countries, Pimco’s Bill Gross told CNBC Monday.

Much of the public focus is on the nation’s public debt, which is $14.3 trillion. But that doesn’t include money guaranteed for Medicare, Medicaid and Social Security, which comes to close to $50 trillion, according to government figures.

The government also is on the hook for other debts such as the programs related to the bailout of the financial system following the crisis of 2008 and 2009, government figures show.

Taken together, Gross puts the total at “nearly $100 trillion,” that while perhaps a bit on the high side, places the country in a highly unenviable fiscal position that he said won’t find a solution overnight.”To think that we can reduce that within the space of a year or two is not a realistic assumption,” Gross said in a live interview. “That’s much more than Greece, that’s much more than almost any other developed country. We’ve got a problem and we have to get after it quickly.”

As the old saying goes, there are lies, damn lies and statistics.

To even imply that the United States is worse off than Greece is pretty amusing — especially now that Greece is splattered all over trader’s screens like roadkill on a windshield.

So how does the United States differ from Greece in ways that materially affect the bond situation? Let us count the ways:

  • The United States is a military and agrarian superpower.
  • The United States accounts for roughly 25% of global GDP.
  • The United States is the issuer and printer of the world’s reserve currency.
  • The United States owes in its own paper.
  • In the eyes of massive creditors such as China, Japan and a majority of global central banks, the United States is “too big to fail.”

Are we trying to write off America’s long-term fiscal problems? Absolutely not!

But suggesting that the U.S. is in worse fiscal shape than Greece, from a logistical / tactical perspective, is like comparing J.P. Morgan to the Bumbershoot Bank of Topeka Kansas. Greece is screwed, but the only reason we care is because of deeply embedded systemic risk. Were America to be screwed, so would the world. The comparison is more hyperbole than fact.

Further, re, “too big to fail:” As goes America, so goes the globe — still. Guess what happens in the aftermath of a true U.S. economic collapse?

The price of oil collapses, which means the Middle East goes haywire. (Saudi Arabia and other nations can no longer afford sustained pricing below $80 or $90 a barrel.)

The value of exports and world trade collapses (America is ~25% of GDP, remember, and a very important “vendor finance” customer) at a time when China is nowhere near ready to stand on its own two feet — which means Asia goes down too.

Not only is the U.S. genuinely “Too Big To Fail” in many respects — with the important advantage of a still dominant military and agrarian position — Uncle Sam also has the ability to buy bonds with dollars. This activity risks serious inflation in the long run, but as Keynes liked to say, “In the long run we are all dead.”

We have argued forcefully in the past that bad U.S. policies ultimately pose serious inflation risk, as the cost of unproductive spending is ultimately born out through inflation / reflation (distributing the hidden costs of debt).

And yet, have you seen the trajectory of the price of oil lately? It collapsed 4% in one day this week. Does the market seem genuinely worried about inflation to you?

Gross professes to understand the desire for safe haven assets. (That’s another big draw of USTs: A global shortage of liquid places to hide.) But Gross argues Canada, Germany or Australia would better serve than the U.S.:

“Why wouldn’t an investor buy Canada with a better balance sheet or Australia with a better balance sheet with interest rates at 1 or 2 or 3 percent higher?” he said. “It simply doesn’t make any sense.”

Should the debt problem in Greece explode into a full-blown crisis—an International Monetary Fund bailout has prevented a full-scale meltdown so far—Gross predicted that German debt, not that of the US, would be the safe-haven of choice for global investors.

Okay, fair question. Why not Canada, Australia or Germany?Why would bondholders still go to the U.S., apart from reasons of size, liquidity and tradition?

We’ll hazard some guesses:

The Canadian dollar and Aussie dollar are “commodity currencies.” We are profitably short both as of this writing — or rather short AUDUSD and long USDCAD — as the overleveraged commodity complex continues to unwind. In our view there are still way too many “long term conviction” players holding long-side commodity bets without adequate risk control in their portfolios. These “conviction players” — who tend towards too large positions and too much confidence — are candidates for driving the commodity complex much, much lower if further price declines fuel a feedback loop of distressed selling.

Australia is a leveraged call option on China. The land down under has been enjoying an unprecedented economic boom, to the point where high school graduates are being offered six figure salaries to drive haulpacks for the big mines. Australia’s main business is providing a steady flow of natural resources to China, and business is booming. But what happens if the China miracle implodes? Jim Rogers, the most vocal of all China bulls, has acknowledged that China could endure a 1907 or 1929-style event on its way to dominance. Such an outcome would be disastrous for Australia’s commodity-leveraged economy.

Canada and Australia have major housing bubbles. There is a website called “Crack Shack or Mansion,” www.crackhouseormansion.com, inviting you to guess whether the photo is one of a drug den or a Vancouver home going for C$1 million or more. Thanks to China buying and the natural resource boom, Vancouver’s housing market is out of control. The same phenomenon exists in Australia — last year, legendary investor (and bubble spotter) Jeremy Grantham of GMO called the Aussie housing market “a time bomb.” Once again, more leverage to China and natural resources here. If the global economy slows and the commodity complex blows out, guess what?

Germany’s medium-term financial fate is a significant unknown. Gross suggests Germany’s bonds would be a better buy in the event of a true eurozone crack-up. Except who knows what that event would do to the German economy? Were the Deutschmark to return, it’s possible that investors would storm the gates like rabid 13-year-old girls at a Justin Bieber concert, driving the DM so high that Germany’s export engine blows a gear overnight. It’s also unknown just how much true exposure the German banks have, or how big a check Germany might have to write were the eurozone to truly implode. Can you imagine if the contagion hits Spain? Italy?

UST flows are logistical as well as tactical. If large institutions have protocols in place for switching to government bonds under certain circumstances, it’s not an easy thing to change the mix of which bonds they buy. In some sense, then, buying USTs is like buying IBM in the old days — as the consultants used to say, “You can’t get fired for buying IBM.” You could get fired, however, for getting fancy with an unorthodox choice and having it blow up in your face. “Better to fail conventionally than unconventionally” etcetera — institutional change happens at a glacial pace.

Big Players Still Buying

Oh, and by the way, the big players (including China) are still buying USTs. Via the WSJ:

WASHINGTON—China bought U.S. Treasurys in April, boosting its holdings after five straight months of net selling, and remained the largest foreign holder, the Treasury Department said. Overall, foreigners were net buyers of long-term U.S. financial assets in April…

If they were buying in April, how much more would that apply in May and June thus far?

Once again, we are not diehard bond bulls by any means. We aren’t even long USTs at this point.

But it’s important to recognize and pay attention to not just the long term drivers, but also the short and medium term drivers of this market.

Again, look at the charts… those pundits railing on about America’s fiscal situation simply do not have the market’s attention right now. The front and center worries are (1) global economic slowdown, (2) Europe / China dislocation, and (3) a speculative unwinding of the $USD carry trade and overleveraged longs. These factors are favorable, not disfavorable, to USTs, for the time being.

So if you want to rail on about America’s terrible fiscal outlook — and the tragedy that it will ultimately cause — fine. But remember to do it wearing your “concerned citizen” hat. Because if you try and do it wearing your trader’s hat, you’ll be way out of sync with the market. At least for now.

Speaking of speculative unwind, feast your eyes on this chart (hat tip Niels Jensen of Absolute Return Partners):

This highlights another factor in the outperformance of USTs, and in our view, potentially THE dominant factor driving markets right now.

Catalyzed by an increasingly jarring series of top down macroeconomic shocks — chaos in Europe, ugly data points from the U.S., hiking in China etc. — we are witnessing the potential unwind of a huge amount of long-side leverage built up as a result of the “Bernanke Put.”

When the Federal Reserve so recklessly encouraged investors to go out and speculate as the government propped up the stock market, his message was well heeded. Margin levels were ramped back up, nearly to the heights of old excess in the final stages of the pre-2008 bubble.

But now, as the deflation shock scenario comes back with a vengeance, that excess bullishness is looking like a giant “oops!” as stimulus juice runs out and further market support is stymied by political backlash and inflation fears.

Pity the fate of mega-bulls like John Paulson (via WSJ):

Prominent hedge-fund investor John Paulson, who runs the $38 billion Paulson & Co., has suffered sizable losses in recent weeks amid fresh worries about the global economy, pushing a key fund deep into the red for the year so far.

Mr. Paulson’s $9 billion Advantage Plus fund lost more than 13% in the early part of this month, through June 10, leaving it down 19.65% for the year, according to two investors briefed on the performance.

The Enhanced Partners fund, which had been a big winner this year, lost nearly 7% in the first 10 days of June, and now is up less than 4% in 2011, according to the investors.

Down nearly 20% for the year — and barely at the halfway mark? Good grief, what happens if a leverage unwind truly begins in earnest?

We remain fascinated by guys like Paulson… and the “Blue Gold” oil fund that lost 20% in May but kept its long oil bets… because the delicious question remains, what if these guys are forced to sell?

It’s the Risk Manager Where Art Thou thing again. Doubling down on positions that go against you — or holding positions that are way too large as they tank — is all well and good if the position works out. Your investors view you as a hero in those situations (or at least those who don’t know any better).

But if the position goes too far against you — if your lack of risk management catches up with you — then at some point you are forced to sell, either through redemptions or survival instinct, at which point your blood carries the market lower.

As Dow theory pioneer Robert Rhea observed, the final bear market stage “is caused by distress selling of sound securities, regardless of their value, by those who must find a cash market for at least a portion of their assets.

We can’t help but note the margin chart and wonder: How many fat and happy hedgies with sweet reflation dreams are waking up to deflationary shock treatment and redemption nightmares now? And how much further could a mass “speculative unwind” carry bonds and the $USD?

Warm Regards,

JS

Recent Themes & Trends (scroll for archives)



2 Responses to The Bond King Gets Desperate

  1. Jack Sparrow on June 16, 2011 at 2:57 pm

    On reader request, quick clarification on the Saudi oil budget (via FT, third para):

    Saudi Arabia could need the oil price to average more than $100 a barrel by 2015 to sustain the big public spending rises it plans in an effort to forestall the political unrest sweeping the Middle East.

    The oil market is growing increasingly worried about Riyadh’s fiscal needs as it fears that they could force Saudi Arabia to pursue oil policies similar to those of Venezuela and Iran, traditionally the price hawks at the Opec oil cartel.

    The break-even oil price the Gulf kingdom requires to balance its budget will jump from $68 last year to $88 this and then $110 in 2015, according to new estimates by the Institute of International Finance, a leading industry group.

    http://www.ft.com/intl/cms/s/0/87d60044-5bbb-11e0

  2. Michael McGillicutty on June 17, 2011 at 2:36 am

    One of your best write ups to date. Thanks.

Leave a Reply

Your email address will not be published.