Monday, November 23, 2009

The Next Bubble: Disclaimer and Disclosure

Believing or disbelieving in the bond bubble seems to have become a political choice, at least in the United States. I can’t recall such a degree of partisan frenzy in the debate over previous bubbles such as housing, tech stocks or commodities. And for good reason: any discussion of bond prices and interest rates leads inevitably to a discussion of budget deficits and Fed/Treasury policy, which – unlike say dotcom valuations – is ideologically fraught territory.

So, in the interests of full disclosure, and for what it’s worth: I am not a US citizen or resident, I do not pay US taxes or receive US benefits, I am not currently connected with the US financial industry (except as an external observer and generic investor), and I do not support any US political party. In short, I have no dog in this race.

All I want to do is understand what has happened, what is happening, and what will happen, insofar as (and no further than!) it helps me as a trader and investor. And my current understanding, based I hope on unbiased analysis, is that we are in the middle of a bond bubble. I think that interest rates may go lower over the short term, but that they will go higher – significantly higher! – over the medium to long term. My portfolio is positioned accordingly. If I get my predictions correct, I will make money; if I get them wrong, I will lose money. It’s as simple as that.


  1. If one doesn't know when the bubble will pop, how does one position one's portfolio for the medium to long term without losing money in the short term?

  2. Unfortunately there’s no foolproof way of doing this; if there were, bubbles would be a lot easier to profit from!

    But here are a few ideas:

    1. Use options. For example, buy out-of-the-money Treasury puts or payer swaptions. If interest rates rise dramatically (if the bubble bursts) then you will make a lot of money; if interest rates stay the same or fall (if the bubble keeps inflating, or for that matter if your analysis is wrong and there is no bubble) then all you lose is the option premium that you paid upfront.

    Alternatively if you don’t want to spend any money upfront then you could finance your purchase of long-dated puts by selling short-dated puts: this is equivalent to betting that interest rates will rise, but not just yet. (Though in this case your downside is not limited as it was in the previous case.)

    Incidentally, the ‘skew’ in the Treasury options market – the difference in cost between puts and calls – is at a multi-year high. In (naïve) bond-market theory, the skew should be close to zero: the assumption is that rates are equally likely to move up or down, as per EMH. The extent to which the skew deviates from zero is a reflection of the relative demand for protection against higher / lower rates. A very wide positive skew (as is the case today) suggests strongly that market participants are worried about rising interest rates and want to buy options to profit from such an event.

    2. Buy option-like securities. Buying put options at such wide skews (high premia) doesn’t seem a very efficient trade, so an alternative strategy could be to buy assets that have option-like performance characteristics in case of an interest rate spike. Gold is the canonical example: if rates go up a lot and we enter a clearly inflationary regime, gold will do spectacularly. But if rates don’t go up and the economy stays moribund, gold will probably lose some ground but hopefully not a huge amount. That’s a classic option-like (non-linear) payoff profile.

    Of course, gold, like the skew, is also at record highs, suggesting that this strategy too is rather crowded. But maybe there are other interest-rate-put proxies out there for you to exploit – silver perhaps?

    (Digression: I’m reminded of a very elegant trade put on by a hedge fund manager – not me! – around the start of the decade. This manager believed that oil prices were going to go up, a lot. Unfortunately, many other market participants shared this belief, and so the price of call options on oil was very high. Seeing this, the manager scouted around for a proxy, and he found it. Instead of buying oil or calls on oil or even established oil companies, this manager invested in a number of ‘expensive’ oil producers – tar sands, oil shale, sub-arctic and deepwater drillers and so on. These producers were not economically viable with oil at $30 a barrel (which was the price at the time) and as a result they traded for pennies. So the manager was able to load up at a low cost. Then, when oil went north of $80 a barrel, suddenly these producers were not just economical but wildly profitable. The manager’s penny stock portfolio turned a huge profit. That’s a great example of getting the fundamentals right, and then structuring a trade to take full advantage.)

    3. Trade dynamically. This is the easiest to conceptualize and the hardest to execute. Basically you want to stay long the (bubbly) asset until the market peaks, and then turn around and sell it short. And you want to do this without getting whipsawed. Not easy! But not impossible either; a clever combination of trailing stop-losses, quick reversal trades, and adding to your winners might be able to do the trick. (The precise parameters depend on the market in question; the danger of course is that you over-optimize on past history – what’s known as curve-fitting – and lose robustness for future predictions.)

  3. I feel glad to read this informative post. Nice financial blog. Thanks.......