Monday, January 12, 2009

Lessons from shorting JGBs – the credible promise to be reckless

I once lost money shorting Japanese Government Bonds (JGBs). It was a funny sort of trade – because I am normally allergic to leverage – but this was one of those exceptions – and even though I was levered and wrong I did not lose much money. I just lost it with the sort of grinding relentless certainty that feels really bad.

A background to the trade

The logic was as follows. Seven year JGBs were yielding about 130bps. The government looked like it would try quantitative easing – and that there was a chance – albeit small – that inflation could take off.

If you shorted seven year JGBs you were obliged to pay out 130bps (plus or minus small borrow fees or derivative margins) for seven years. Given short rates were zero at the time, being short JGBs and long cash had a negative carry of 130bps. It was painful – but not very expensive. If you shorted 100% of your wealth the negative carry would be 1.3% of your wealth per year.

The maximum loss would obtain if the seven year JGB suddenly traded – like cash – at a zero yield. Then you would lose the entire seven years of spread at once – or about 10% of your wealth all of a sudden. This would be painful – but is tolerable as a maximum theoretical loss. (Its not uncommon to have 10% of your wealth in a stock portfolio at any time.) Moreover the largest practical loss was a few percent of your wealth – somewhere near my actual loss.

A bad trade – and normally I would suck it up – learn a lesson and go on.

But times like this remind me again of the fortune you could make if inflation returned. Suppose – and it was unlikely in Japan – that inflation really took off – and bond yields went back to 7.3%. Roughly (and there is plenty of bond maths I am over-simplifying here) you would make 6% times seven years discounted a bit in profit – a very big profit on a trade with a seemingly small maximum loss. Indeed the gain might be 20 times the practical maximum annual negative carry.

And it struck me that the chance of inflation was real – and under-priced. Over time I found different ways to lose money betting on the possibility of reflation in Japan – most notably on Japanese regional banks (see this post on 77 Bank).

Moreover – I was just betting on policy being something other than entirely stupid. But for that you need my (admittedly trivial) understanding of where asset price deflation got to in Japan. Lets start closer to home – Australia.

Asset price inflation in Australia and deflation in Japan – or why Ben Bernanke wants to throw money out of helicopters

In Australia it became absolutely standard practice to buy real estate with negative carry. The idea was that you could buy a house for 100 thousand using 7% money and have a 3% rental yield. You made a 4% loss each year. The 4% loss could offset other tax. But everyone accepted it because house prices rose more than 4% a year and the capital gains tax was (slightly) concessional. The negative yield was sustainable so long as people continued to expect property prices to rise.

Well there was a point where Japan was the reverse of this. Banks would fall over themselves to lend you money at 1% to buy property with a 4% yield. You got 3% positive carry in a land where almost everything yielded something close to nothing. And yet people wouldn't do it. Why not? Because everyone knew that property prices fell more than 3% per yield. Positive carry was not enough to offset property price deflation.

When things deflate at 3-5% per year then money in the bank at zero interest (of which the Japs have plenty) is a very fine investment – it yields 3-5% per year post tax real – and it is very low risk. Obviously that was a better investment than almost everyone made in 2008. In realty it is an investment better than is available to most people anywhere.

And if everyone thinks this way (cash is good, borrowing bad, don't buy assets because they fall in price) then the situation is self-sustaining. Welcome to Japan.

Japan deflated because – well everyone thought it would continue to deflate. And that led to a lack of domestic investment and (eventually) the Japanese – like the Chinese – managing to fund a whole lot of really dumb lending in America. It was just bad.

Lots of people could see this – Krugman and Ben Bernanke to name just two. And a simple shock to the system which convinces people that holding the money in the bank is stupid and that they better go out and buy real assets would fix it.

What you needed was to credibly convince the population that deflation was over – and that there would be inflation. What the BOJ needed to do was credibly promise to be irresponsible.

You have to convince that cash-is-trash.

How do you do this? Well the first answer is just print money.

And that is what the BOJ did – and what central banks around the world are still doing. And it doesn't work. The reason that it doesn't work is that people are more than happy to hold the money idle in enormous quantity. It yields 3-5% post tax real after all.

Just printing money is not enough. You need a real shock.

The Ben Bernanke suggestion – and he really did suggest this: load up a helicopter and throw it out the window over downtown Tokyo. If that doesn't work continue doing it until you get inflation.

This would be a dramatic uncontrolled experiment – and it could induce LOTS of inflation. In Japan bank deposits are a large multiple of GDP – and very large per capita relative to America. If the Japanese were shocked into believing that cash is trash they might try to spend these on assets very fast – and that might produce dangerous outcomes. The BOJ dismissed Kruman's suggestions as “dangerous”. And they probably were dangerous – but they might have been better than years of continued deflation.

Anyway they chose continued deflation and my short JGB position lost money.

Now Ben Bernanke is in charge

Ben suggested helicopters for Japan. He wants to credibly promise inflation in the US too. Ben is – I suspect – good for his word – even though the bond market sees it otherwise.

And if it comes to the crunch my guess is that he will charter the helicopter. He will pick a middle income state (Iowa – because it is politically sensitive?) and drop cash.

Maybe – less reckless in appearance than throwing money out of helicopters would be the Fed turning up at schools with big piles of crisp $20 notes. Whatever. He wants to credibly promise to be reckless.

Giving money in one-off tax breaks (as per Australia or Bush's various plans) is not the same thing. That money isn't freshly printed cash. You need to credibly convince the populace that you are prepared to risk the Zimbabwe outcome. You have to credibly promise to be reckless.

Bernanke knows this. He is on the record for suggesting it.

So when do you short treasuries?



KLM said...

The time here says 5am, perhaps that is why I can't stop laughing..., but it's something about the image of the most powerful people in the lands sitting around a table with serious faces when the big boss goes: "I know what to do: we'll let the air force drop cash from helicopters. Problem fixed!".

Wonder what Obama would say

Trug said...

Personally I like Mish's argument that Fed has no palatable way to "be irresponsible." Americans have an extremely negative perception of welfare payments for the masses and giving away money (even in Iowa) would just piss off the 99.99% of the population that didn't get a piece of the action.

IF said...

How is shorting treasuries different from signing a 30 year fixed mortgage? Could the country already be net short treasuries? Pretty crowded trade...

epicaricacy said...

How do you square an idea of shorting treasuries with the fact that Bernanke's currently announced method of quantitative easing is for the fed to purchase treasuries? I suppose as you stated in the post it is a manner of timing...

MC Shalom said...

Chairman Ben S. Bernanke, Quantitative Easing Can't Work.

In a Liquidity Trap although Saving (S) is abnormally high investment (I) is next to 0.

Hence, the Keynesian paradigm I = S is not verified.

The purpose of Quantitative Easing being to lower the yield on long-term savings and increase liquidity it doesn't create $1 of investment.

In a Liquidity Trap the last thing the Market needs is liquidity. This is why, Mr Chairman, we call it a Liquidity Trap,

Force-feeding the Market won't achieve anything useful.

If short-term risk free interest rates are at 0.00% doesn't that mean that credit is worthless?

Quantitative Easing does diminish the yield on long-term US Treasury debt but lowers marginally, if at all, the asked yield on long-term savings.

Those purchases maintain the demand for long-term asset in an unstable equilibrium.

When this disequilibrium resolves the Market turns chaotic.

This and other issues are explored in my tract:

A Specific Application of Employment, Interest and Money
Plea for a New World Economic Order


This tract makes a critical analysis of credit based, free market economy, Capitalism, and proves that its dysfunctions are the result of the existence of credit.

It shows that income / wealth disparity, cause and consequence of credit and of the level of long-term interest-rates, is the first order hidden variable, possibly the only one, of economic development.

It solves most of the puzzles of macro economy: among which Unemployment, Business Cycles, Under Development, Trade Deficits, International Division of Labor, Stagflation, Greenspan Conundrum, Deflation and Keynes' Liquidity Trap...

It shows that no fiscal or monetary policy, including the barbaric Quantitative Easing will get us out of depression.

A Credit Free, Free Market Economy will correct all of those dysfunctions.

The other option would be to wait till, on the long run, most of our productive assets get physically destroyed either by war or by rust.
It will be either awfully deadly or dramatically long.

In This Age of Turbulence People Want an Exit Strategy Out of Credit,

An Adventure in a New World Economic Order.

We Need, Hence, Abolish Interest Bearing Credit and Cancel All Interest Bearing Debt.

Exit Strategy Out of Credit

A Specific Application of Employment, Interest and Money
[Intended for my Fellows Economists].

Press release of my open letter to Chairman Ben S. Bernanke:

Chairman Ben S. Bernanke, Quantitative Easing Can't Work!

Yours Sincerely,

Shalom P. Hamou AKA 'MC Shalom'
Chief Economist - Master Conductor
1776 - Annuit Cœptis.

Mark Brinkley said...

There is another way out of this mess. That is for governments to start buying assets and set a floor on the price. If governments started buying real estate at distressed prices and promised to be a buyer of last resort once prices had fallen to a certain level, then a floor would be set and people would have the confidence to start trading once more. It would be a hell of a lot cheaper and simpler than throwing money out of helicopters.

Mark Cheshire said...

Currency is the biggest risk or gain from taking on trades like this.

For folks wishing to short from a regular brokerage account, what it the most effective way to do this? I don´t believe that Treasury Bonds can be shorted in a regular account. From what I have read inverse ETFs like the double short TBT have tracking problems (leakage) over longer time periods. Is shorting the ETF like TLT the way to go? But isn´t the carry a lot higher because in addition to paying the monthly dividends you have to pay around 8% for margin interest to the broker. Any ideas on how to do this more effectively?

John Hempton said...

Mr Cheshire. Two words: bond futures.

Anonymous said...

Instead of helicopters, or given the size of the problem leasing the US air force B-52 fleet, Uncle Ben could just send every American household a cheque for $10.000,- courtesy of the Fed and redeemable for a limited period of time. That should get people to spend. If not, he can always reload and send $20.000,- next time, then $30.000,- and so on. Paper cash is so last century.

But this begs the question, will Uncle Ben be permitted to use such extreme actions or will the Mellonists get their way and liquidate all assets? If the latter, a treasury short will lose money.

I may short treasuries when I know who wins the great policy debate, liquidationists or Kenyesians.

Aig said...

John, thank you for the article, extremely useful!

Intellectually I fully agree. Coincidentally, my mechanical TY (US 10yr T-note) trading system is short full position. However, I've NOT yet turned off long signals either due to some lingering doubts ...

1. If Fed has pumped in the system about $2t while the aggregated losses in the markets are $8b ... there needs to be much more $ than one can load in helicopters before it leads to inflation.

2. I model money supply for all major currencies. The model implies strong USD, JPY, particularly against GBP and AUD. Strong currency is conducive to low inflation and strong bond market. We've to see JPY and USD fundamentally weaker before we see bond prices to go down.

3. As Keynes noted, "market can remain irrational longer than you/me/anybody can remain solvent". Perceptions can drive prices elsewhere. Including the perceptions about Jap real estate market outlook ...

Those are the reasons I've not yet turned off long trades for TY (but I'm close to it).

Aig said...

correction: $8t, not $8b

There is another very important angle. And it's cultural.

My best guess is that U.S. bonds will ultimately decline or even collapse. Japanese bonds are less likely to do so. All the explanations are rooted in different mentalities of the two nations.

Japanese work through their problems slowly and "surprise" is a bad word. U.S. cleans it's house quickly and move on with little emotional attachment to the failures of the past. In Japan they have savings rate of 30% or so, in U.S. it is close to zero. In U.S. the central bank seems to be afraid of deflation as a prerequisite to depression. In Japan they don't seem to mind, unless it gets too damaging.

It is a big difference how you respond to losses. If major players act in accord and decide to write down, say $8t in losses, gradually in 10 years ... or 15, or may be 20 ... then you are likely to talk about Japan. If major players present competing ideas and ultimately write down the same amount of loss in 1 year ... then it sounds more like U.S.

Besides, even if all the Japanese housewives again divert 1/5th of household investable assets to fund a new massive global carry trade, it still has little bearing to savings & inflation in Jap.

Joe said...


TBT is an ETF that is synthetically short Treasuries, there are several others. Because it's an ETF you can invest in it in any brokerage account (IRAs etc.)

neil said...

"The maximum loss would obtain if the seven year JGB suddenly traded – like cash – at a zero yield"

0% yield isn't the floor for yields. They can go negative, even deeply negative. I think your maximum loss is much more than 10%. With a duration of 10 years, a move to -3% would be a 30% loss. There is nothing stoping them trading at $1300.

Anonymous said...

Demographics may also aggravate the cash-is-king mentality as Japan's "baby boom" population bulge is older than the comparable American baby boom cohort.

If now in the US baby boomer grow tired of being burned in, properties, etc., then in America cash may be king as well as the boomers age.

Anonymous said...

... when the velocity of money >1 is probably going to be the most reliable signal. Thanks for sharing the history lesson JH, cheers, JL.

Anonymous said...

nice post -- i have been enjoying your blog.

as it would be politically unsavvy for bernanke to drop dollars from the sky anywhere in the US, how about chartering a helicopter and dropping them from the sky somewhere in china?

cp said...

Hi John,

This is one of the best blogs I read - keep up the good work.

Have you read Richard Koo's "The Holy Grail of Macroeconomics: Lessons from Japan's Recession"?

Koo presents some pretty interesting evidence that bonds are not in a bubble until private sector credit demand rises (he points out that M0, M2 and domestic credit disconnected from each other shortly after the bubble burst). The crux of the argument was that the savings that get trapped in the banking system as individuals & corporates pay down ended up being parked in JGBs because there was no private alternative (nobody wanted to borrow). So the government can borrow and spend as much as it likes, and the central bank can employ increasingly "exotic" policies, but it won't generate inflation. It's interesting that M2 continued to grow at ~2% rate in Japan but there was no inflation (indeed, if you compare M2 and domestic credit, if the "textbook" economics relationship continued, M2 would have fallen by 37% (vs 33% for the Great Depression) were it not for the Government's fiscal actions.

I must admit that I believed that short USTs here could be a lay-up trade, but the above makes me think twice. I guess we need to see what happens to loan demand.


Clayton said...

How about some kind of expiration date on money.... like a coupon. Granted this would totally throw off the theoretical underpinnings of money as a store of value and push us towards hot potato monetary velocity but maybe something more moderate like stimulus accounts that expire if not spent within 18 months?

Anonymous said...

are we there yet?

Seems like people are finally starting to believe that Bernanke will be "credibly reckless"

As of this morning, the intelligentsia is all abuzz about bernanke being "behind the curve on the economic recovery".

when do you short treasuries? seems like now to me.

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