Trading Fixed Income: Falling Knives, and EM local (market views)

Do you think the selling in the Treasury complex is over–at least until next Friday’s NFP? It you are a trader, this is really the only question you have to ask yourself right now.

There has been massive pain in the fixed income world over the past three weeks. The backup in Treasury yields finally attained the speed necessary to shake carry traders across the FI spectrum into shedding risk. It got particularly ugly in EM local fixed income and currencies (more on that later). The risk-shedding eventually spilled over into the equity markets.

Odds are good now that we are at that kind of win-win juncture for FI risk that you don’t that often see. Kind of a David Tepper moment for FI traders. I think the selling in the T-plex has been strong enough for long enough that it would take big fundamental news to drive them further down from here. And I can’t see anything important enough in front of the NFP to fit that bill.

This leaves us with two basic scenarios. One, if the equity market rebounds, the ‘fear discount’ now built into a lot of FI instruments will come out and Treasuries should stabilize if not rally, given the speed, fear and volume behind the recent selling.

Two, if, instead, the equity market sells off further from this point—which we got a taste of on Friday—then Treasuries will rally, as they tend to when risk aversion rises far enough or fast enough in equities. In fact, we got a taste of this on Friday as well. This scenario should trigger at a minimum a modest rally in the some of the FI instruments hit hardest by the bond selloff.

Both scenarios have implications for the dollar and tend to be bearish, but more on that below.

Of course, if your scenario doesn’t envision Treasuries stabilizing, then you stay just out of the way.

If, however it does, you then have to consider the follow-up, investor question as well: Has the market too aggressively discounted the timing of the Fed’s exit process? This is not the same as the first question. If you believe the answer to this question is also yes, then this is probably a good entry point to buy beaten up FI instruments for a longer timeframe, not just for a trade (FWIW, less than 3 months is the trading bucket, more than 3 the investment bucket).

Three FI sectors warrant separate discussion here, IMO: Agency mortgage REITs, currencies and EM local currency bonds.

Agency Mortgage REITs

  • Selloff started last September
  • The sector is now retail-dominated and emotional
  • I put the current discount to NAV at ~10%–but this is a guesstimate, conditioned in no small part by the magnitude of the decline in book value last quarter
  • The sector is in cyclical downswing, but discount to NAV and carry offer good protection right now against being wrong, even when dividends are cut.

Ccy, PMs and EM local FI

Correlations have been low, making things tricky. Positioning is heavy and will be the driving force in the near term, IMO, especially if the equity market tumbles further. If you believe USTs will stabilize, you are likely to see a decent rally in funding and hedging currencies (EUR, GBP, AUD, NZD, CAD), and in JPY where positioning is so heavy even higher UST yields were unable to lift USDJPY. You’ll also likely see a squeeze in precious metals, where a lot of shorter-term traders and CTAs are positioned short. Even though I dislike precious metals in the longer term, I think odds right now favor an especially good trading opportunity in the gold miners. There’s a fair number of people long dollars against the majors and precious metals at this point. Caveat: short dollars anywhere except JPY gets a lot trickier if USTs stabilize and SPX sells off hard.

It is less clear how much EM currencies rally if the big dollar sells off, if at all. This is an area where there still is short-dollar positioning, and, frankly, it is humongous. USDMXN has moved 80 big figures and long-term holders were only just roused from their slumber last Wednesday. My guess is any rally in EM currencies will be used by institutional investors to lighten up, driven by this wake up call and their longer term cyclical views.

The big trade for many macro types has been long EM currencies and short a basket of developed currencies. This allows macro guys to be long EM ccys while diversifying away much of the EURUSD risk by using a funding basket. Shorting AUD hedges SPX and Asia slowdown risk as well. This trade is as old as dirt. Problem is there are many more guys holding dirt these days. And RM, both dedicated and crossover, have piled into EM local ccy bonds (look at the ticker $EDD). Few outside the asset class know how large it has grown relative to the target market. And those in the asset class have kept mum to increase AUM.

These local bonds are too difficult to sell in size, so if redemptions get large enough where RM funds have to reduce bond holdings, it will get ugly. In the meantime, the big investors will buy dollars against their EM local bond holdings to protect those positions as best they can. Few investors in EM local ccys bonds realize the extent to which overall returns in the space are driven by currency and not the bonds themselves.

I know EM fundamentals are better in most EM countries these days, but that is not much of a defense once we tip over into the liquidation mindset—and odds are good that we have. The participation in the asset class is just much, much broader than it has ever been. Plus, the sell-side market-making is a lot thinner. So, even if you think USTs stabilize, this is not the asset class to play. Many large players will be looking for the exit on any decent bid.