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The Bond Bubble Collapse Thread; Reset Time. This is the End of the Line for All the Rolling Bubbles Propped Up in the last 30 Years
Topic Started: 21 Aug 2016, 04:02 PM (11,437 Views)
b_b
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Jon Snow
15 Sep 2016, 08:51 PM
What's an FI?
Financial Institution
createdby
15 Sep 2016, 03:14 PM
Long gone? LONG GONE? BULLSHIT! 2 and 20 model was for a long time hedge fund industry standard fee and still is to some extent today. It's only in the last year or two where many funds have discounted. But long gone?

https://www.bloomberg.com/gadfly/articles/2016-08-25/och-ziff-capital-puts-another-nail-in-2-and-20-coffin
ok - so you do not know how FI’s provide currency hedges without exposing themselves to currency risk (and not taking on hedges themselves).

Stay dumb. It suits you.
Edited by b_b, 16 Sep 2016, 09:42 AM.
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Jon Snow
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b_b
15 Sep 2016, 08:57 PM
ok - so you do not know how FI’s provide currency hedges without exposing themselves to currency risk (and not taking on hedges themselves).
Well I'm curious.

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https://www.ft.com/content/e82b8210-79c0-11e6-97ae-647294649b28
Negative Interest Rates
The alchemists who turn negative bond yields into profit
Canny investors can make the most of the dollar rise offsetting the yen loss
6 HOURS AGO by: Gillian Tett
Posted Image
Why on earth would anyone buy a bond that yields a negative interest rate? That is the $12.6tn question gripping global markets as the pile of negative yielding bonds mounts. If you ask investors, they typically offer two replies: “desperation” (they cannot think of anywhere else to park their funds) or “regulation” (they have to buy bonds to comply with financial supervision rules or investment mandates).

But there is a third explanation: some investors have found ways to make those negative yields pay — and not just through traders “churning” bonds to generate commission.

The real cause is that government intervention to reinvigorate stagnant economies has left markets so peculiarly distorted that there is potential for canny alchemy — and profits.

For one example of this, look at dollar-yen cross currency swaps. This rather esoteric corner of finance normally goes unnoticed by the wider world. But right now there are two reasons it merits greater attention.

First, the Bank of Japan will publish on September 21 a hotly anticipated report about the impact of negative rates. Second, it is evident that recent developments in this swaps market have been bizarre.

The issue at stake is the spread — in effect, the cost of converting short-term yen contracts into dollars. Three decades ago, this spread was around zero, since demand for dollars and yen was evenly balanced. But when the Japanese financial crisis erupted in 1997-98 the country’s banks grew increasingly stigmatised and the one-year spread widened to minus 35 basis points, meaning in effect that anyone converting yen into dollars paid a penalty.

After 1999, the spread returned to zero. It has subsequently widened twice at points when financial crises have sparked a global dash into dollars. In 2008 it hit minus 70bp; and in 2011 during the eurozone debt crisis it touched minus 50bp.

In between, the spread shrank — as you would expect when markets are calm and functioning normally.

What is peculiar now, however, is that since 2015 that spread has widened and stayed at that level, hitting minus 70bp for one-year swaps. That is in part because Japanese institutions are keen to get hold of dollars, to enable them to buy assets that might produce a return at a time when yen rates are negative.

Another factor is that the US is reforming its money market rules, which is reducing funding to dollar markets. To make matters worse, emerging market countries want dollars in order to repay loans. The run of persistently wider spreads hurt the profits of Japanese banks and life assurance groups.

But it also creates a big opportunity for dollar-rich institutions around the world, from Pimco, one of the world’s biggest bond houses, to Chinese sovereign wealth funds.

So what many of these dollar-rich institutions are doing is cutting deals in this cross-currency swaps market, giving counterparties dollars in exchange for yen — and then using that yen to buy short-term bonds.

At first glance, it might seem like a bad idea to buy those yen bonds. After all, short-term bonds have negative yields (currently about minus 25bp). But the crucial point is this: the yen loss is more than offset by the dollar gain, meaning that there are profits to be made even by holding negative bonds. So it makes sense that foreigners are piling in. Chinese purchases of Japanese bills reached a record cumulative ¥10tn in June, according to Bloomberg.

Now, if you want to be optimistic, you might say that this tale simply shows that central bank actions are working: if Chinese and US investors keep buying short-term yen bonds, that will keep yen rates low.

This should — in theory — provide stimulus to the wider economy, by encouraging more borrowing. However, if you want to be more cynical about whether negative rates really work (as I am), you could also point out that these market dislocations have become so perverse that they are sapping confidence in a self-defeating way.

Either way, the question is what — if anything — the BoJ will do next. My own guess is nothing much; these dislocations have become so deeply ingrained in the markets that investors (and policymakers) seem almost inured.

But if you are ever tempted to wonder about those negative rates, ponder on the alchemy behind this peculiar yen-dollar tale. If nothing else, it should remind us how strange our financial system has become — and the shocks that might occur if, say, yen rates suddenly returned to normal.

gillian.tett@ft.com
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Jon Snow
15 Sep 2016, 09:12 PM
Well I'm curious.
Currently traveling. Will post something this weekend.
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Hedgies trying to squeeze alpha better than passive bond funds lol. These mugs are finished when their clients start parking their money in cash and gold.

http://www.afr.com/personal-finance/low-interest-rates-for-not-so-long-20160915-grgwf5
Low interest rates for not so long
by Christopher Joye
Sep 16 2016 at 6:00 AM
Updated Sep 16 2016 at 9:50 AM

Buying "duration" in recent times – or assets like fixed-rate bonds that expose you to long-term interest-rate risks – has been one of the more dangerous trades in human history.

Nobody has any ability to forecast duration – who predicted September's two standard deviation spike in yields? And with government bond yields (prices) at their lowest (highest) levels on record, tail risks are skewed towards savage losses from what are presumed to be safe and liquid investments.

In the first 14 days of September, AAA rated Australian government bonds lost 1.5 per cent (or 152 basis points) of their value even after accounting for their miserly yield.

Blindly loading up on duration by following the mad mantra of "bonds for growth and equities for income" is as silly as the Reserve Bank of Australia claiming that cooling housing conditions gave it room to cut rates in August.

Beyond the boom-time 80 per cent auction clearance rates across the nation's biggest metro markets (Sydney and Melbourne), home values in the five largest capital cities leapt 3.7 per cent in three months to August 13 (a 15.5 per cent annualised rate) based on the best available CoreLogic index data.

Over the first 8.5 months of 2016, Aussie house prices have jumped 8 per cent (or 11 per cent in annualised terms). How the RBA can bring itself to repeatedly describe house price growth this year as "moderate" when wages are only rising at 2.1 per cent annually is anybody's guess.

"It's the greatest short in history," exclaimed the Phoenician honcho at a $2 billion hedge fund a few weeks ago. He was referring to interest rate duration. "No sh-t," I responded. "I've been telling you the same thing for years."

Pure luck

While my friend's timing proved to be impeccable, he would be the first to admit this was pure luck, not skill. Successfully divining changes in duration – or correctly anticipating perturbations in the market's estimates of where risk-free interest rates will be in one to 10 years' time (as expressed by the "yield curve") – is all but impossible for a select few.

If the RBA, which controls short-term rates, has, by its own admission, no ability to accurately project where economic growth will be in 12 months (its 90 per cent confidence interval for 2017 real GDP ranges from 1.0 per cent to 4.75 per cent), it is hard to understand how many fixed-income investors can claim they add value by punting on the direction of rates.

The empirical fact is that over the last three and five years, almost 90 per cent of "active" fixed-income funds have failed to beat their benchmark (the AuBond Composite Bond Index) after fees.

Managers in the much more transparent, efficient and heavily contested equities market have done a much better job with around one-third outperforming the index after fees.

It is therefore amusing to watch media lavish attention on high-profile local bond managers for their "low rates for long" calls when they cannot outsmart their own passive benchmarks.

Any fixed-income investor long duration, which includes most bond funds, has a powerful financial incentive to clamour for easier monetary policy because as yields decline their fixed-rate bond prices climb.

This analysis explains why I personally run portfolios that carry near-zero duration. There is much more to be gained extracting alpha from the immensely inefficient physical credit markets than competing against every other bank, hedgie, fixed-income fund and quant shop second-guessing capricious central banker in the inextricably intertwined interest rate derivatives and foreign exchange markets (exchange rates price off interest-rate differentials). These are arguably the two most efficient asset classes on earth.

Mug's game

So while rates will eventually normalise when governments withdraw from their unprecedented interference with the asset pricing process, projecting the precise timing of this event is a mug's game. In the interim, buying long-term duration is like playing Russian roulette – unless you are, say, a super fund that has to because you are forced to benchmark against the AusBond Composite Bond Index.

The inflexion point for long-term developed-world interest rates will be driven by inflation in the US given the latter is by far the most important marginal price-setter for global bond markets.

My base case has been that the arrival of full employment in the US will boost wages and inflation that will in turn force bond bandits to fight the Fed for the first time in a long time by resetting the long end of the yield curve.

Here it is useful to defer to one of the best sell-side economists, Deutsche Bank's Dr Torsten Sløk.

One of his latest chart packs highlights that most measures of US core inflation are above the Fed's 2 per cent target at 2.5 per cent "and trending higher".

This is also true of one of the key explanatory variables for inflation, "labour unit costs", which are approaching pre-global financial crisis peaks and are "more and more disconnected from Fed policy".

Likewise, "real wages are on a steady uptrend and currently at 2006 levels," Slok says.

Wages in the US have been accelerating since their 2010 trough, and income growth for "job switchers" is "at 2006 levels". "All this is not surprising given how tight the labour market is," Slok continues.

The US jobless rate has fallen from 10 per cent to 4.9 per cent while more crucially the "number of people available per job opening is below 2007 levels".

Finally, corporate profits are rebounding, and "this gives employers more room to pay higher wages".

And yet Slok adds: "Many clients tell me that the Fed can be slow and gradual and cautious because there are no signs of inflation."

That's because they are all long interest rate duration via their equities, fixed-income and property portfolios. Drink the "low rates for long" Kool-Aid at your peril.

Christopher Joye is a director and shareholder in Smarter Money Investments, which manages fixed-income investment portfolios.



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Terry
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Fantastic link by the way. Gillian Tett. Classy. And I'm not taking the pis.
createdby
16 Sep 2016, 12:22 PM
Hedgies trying to squeeze alpha better than passive bond funds lol. These mugs are finished when their clients start parking their money in cash and gold.

http://www.afr.com/personal-finance/low-interest-rates-for-not-so-long-20160915-grgwf5
Low interest rates for not so long
by Christopher Joye
Sep 16 2016 at 6:00 AM
Updated Sep 16 2016 at 9:50 AM

Buying "duration" in recent times – or assets like fixed-rate bonds that expose you to long-term interest-rate risks – has been one of the more dangerous trades in human history.

Nobody has any ability to forecast duration – who predicted September's two standard deviation spike in yields? And with government bond yields (prices) at their lowest (highest) levels on record, tail risks are skewed towards savage losses from what are presumed to be safe and liquid investments.

In the first 14 days of September, AAA rated Australian government bonds lost 1.5 per cent (or 152 basis points) of their value even after accounting for their miserly yield.

Blindly loading up on duration by following the mad mantra of "bonds for growth and equities for income" is as silly as the Reserve Bank of Australia claiming that cooling housing conditions gave it room to cut rates in August.

Beyond the boom-time 80 per cent auction clearance rates across the nation's biggest metro markets (Sydney and Melbourne), home values in the five largest capital cities leapt 3.7 per cent in three months to August 13 (a 15.5 per cent annualised rate) based on the best available CoreLogic index data.

Over the first 8.5 months of 2016, Aussie house prices have jumped 8 per cent (or 11 per cent in annualised terms). How the RBA can bring itself to repeatedly describe house price growth this year as "moderate" when wages are only rising at 2.1 per cent annually is anybody's guess.

"It's the greatest short in history," exclaimed the Phoenician honcho at a $2 billion hedge fund a few weeks ago. He was referring to interest rate duration. "No sh-t," I responded. "I've been telling you the same thing for years."

Pure luck

While my friend's timing proved to be impeccable, he would be the first to admit this was pure luck, not skill. Successfully divining changes in duration – or correctly anticipating perturbations in the market's estimates of where risk-free interest rates will be in one to 10 years' time (as expressed by the "yield curve") – is all but impossible for a select few.

If the RBA, which controls short-term rates, has, by its own admission, no ability to accurately project where economic growth will be in 12 months (its 90 per cent confidence interval for 2017 real GDP ranges from 1.0 per cent to 4.75 per cent), it is hard to understand how many fixed-income investors can claim they add value by punting on the direction of rates.

The empirical fact is that over the last three and five years, almost 90 per cent of "active" fixed-income funds have failed to beat their benchmark (the AuBond Composite Bond Index) after fees.

Managers in the much more transparent, efficient and heavily contested equities market have done a much better job with around one-third outperforming the index after fees.

It is therefore amusing to watch media lavish attention on high-profile local bond managers for their "low rates for long" calls when they cannot outsmart their own passive benchmarks.

Any fixed-income investor long duration, which includes most bond funds, has a powerful financial incentive to clamour for easier monetary policy because as yields decline their fixed-rate bond prices climb.

This analysis explains why I personally run portfolios that carry near-zero duration. There is much more to be gained extracting alpha from the immensely inefficient physical credit markets than competing against every other bank, hedgie, fixed-income fund and quant shop second-guessing capricious central banker in the inextricably intertwined interest rate derivatives and foreign exchange markets (exchange rates price off interest-rate differentials). These are arguably the two most efficient asset classes on earth.

Mug's game

So while rates will eventually normalise when governments withdraw from their unprecedented interference with the asset pricing process, projecting the precise timing of this event is a mug's game. In the interim, buying long-term duration is like playing Russian roulette – unless you are, say, a super fund that has to because you are forced to benchmark against the AusBond Composite Bond Index.

The inflexion point for long-term developed-world interest rates will be driven by inflation in the US given the latter is by far the most important marginal price-setter for global bond markets.

My base case has been that the arrival of full employment in the US will boost wages and inflation that will in turn force bond bandits to fight the Fed for the first time in a long time by resetting the long end of the yield curve.

Here it is useful to defer to one of the best sell-side economists, Deutsche Bank's Dr Torsten Sløk.

One of his latest chart packs highlights that most measures of US core inflation are above the Fed's 2 per cent target at 2.5 per cent "and trending higher".

This is also true of one of the key explanatory variables for inflation, "labour unit costs", which are approaching pre-global financial crisis peaks and are "more and more disconnected from Fed policy".

Likewise, "real wages are on a steady uptrend and currently at 2006 levels," Slok says.

Wages in the US have been accelerating since their 2010 trough, and income growth for "job switchers" is "at 2006 levels". "All this is not surprising given how tight the labour market is," Slok continues.

The US jobless rate has fallen from 10 per cent to 4.9 per cent while more crucially the "number of people available per job opening is below 2007 levels".

Finally, corporate profits are rebounding, and "this gives employers more room to pay higher wages".

And yet Slok adds: "Many clients tell me that the Fed can be slow and gradual and cautious because there are no signs of inflation."

That's because they are all long interest rate duration via their equities, fixed-income and property portfolios. Drink the "low rates for long" Kool-Aid at your peril.

Christopher Joye is a director and shareholder in Smarter Money Investments, which manages fixed-income investment portfolios.



Interesting as always. Question re the U.S. is why retail activity and prices are tanking. Doesn't really gel with the psychology needed to boost inflation. When FMCG companies move from brand value champions to price competitors via private labels, the die is cast.
Edited by Terry, 16 Sep 2016, 12:44 PM.
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b_b
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b_b
16 Sep 2016, 09:39 AM
Currently traveling. Will post something this weekend.
Ok - so how to provide a currency hedge without exposing yourself to currency risk. Best to show by example, and for that we need some basic assumptions.

AUD/USD (Spot) 1.000 (parity)
Term of hedge: 1 year
US Interest rates: 5%
Australian Interest rates: 10%
Fees costs etc zero.

Now assume you have a business that makes widgets in Australia and sells to the US. Assume you just won an order to supply 100 widgets to the US for US$100. The problems is, it will take a year to manufacture the widgets and settle the order. And while its costs A$80 to produce the widgets, a drop in USD could wipe out profits when settlement takes place.

So I come along a guarantee the forward rate (a hedge contract). My guarantee rate is 0.9545. I can do this while taking zero currency risk. How?

Well I know you will received US$100 in one years time. So all I have to do is Borrow USD$95.23 today and use the proceeds to buy A$95.23 at spot. Why this amount? Because US interest rates are 5%, so in 12 months, my US loan will be US$100. Exactly the contracted amount you will received in 12 months.

Meanwhile, in 1 years time the AU$95.23 deposit will increase by 10% to 104.76. I am therefore prepared to deliver AUD$104.76 to you in 1 years time so long as you provide me with US$100. That works out the be a forward hedge rate of AUD/USD 0.9545 (100/104.76). Of course the rate would be a little worse once I take out fees. This rate can be guaranteed whether the currency is 1.50 to 0.50 in 1 year because the USD amount is already known, and I have the AUD funds already organised.

I have zero currency risk with this structure because it is all set up day one. The only risk I have is CREDIT RISK. That is, whether you will actually deliver the USD$100 as contracted.

The real world
Obviously banks do not create liabilities and assets for every hedge. But they do run large hedge books, which usually (though not always) net-out to a very small number. But when the net number becomes large (say a one-off big FX forward for BHP etc), they will hold some foreign liability (in excess of foreign assets) to offset the risk. Either way, if the swap book is properly managed the issue is never about currency risk. It is always about credit risk.
Edited by b_b, 18 Sep 2016, 03:48 AM.
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Terry
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b_b
18 Sep 2016, 03:46 AM
Ok - so how to provide a currency hedge without exposing yourself to currency risk. Best to show by example, and for that we need some basic assumptions.

AUD/USD (Spot) 1.000 (parity)
Term of hedge: 1 year
US Interest rates: 5%
Australian Interest rates: 10%
Fees costs etc zero.

Now assume you have a business that makes widgets in Australia and sells to the US. Assume you just won an order to supply 100 widgets to the US for US$100. The problems is, it will take a year to manufacture the widgets and settle the order. And while its costs A$80 to produce the widgets, a drop in USD could wipe out profits when settlement takes place.

So I come along a guarantee the forward rate (a hedge contract). My guarantee rate is 0.9545. I can do this while taking zero currency risk. How?

Well I know you will received US$100 in one years time. So all I have to do is Borrow USD$95.23 today and use the proceeds to buy A$95.23 at spot. Why this amount? Because US interest rates are 5%, so in 12 months, my US loan will be US$100. Exactly the contracted amount you will received in 12 months.

Meanwhile, in 1 years time the AU$95.23 deposit will increase by 10% to 104.76. I am therefore prepared to deliver AUD$104.76 to you in 1 years time so long as you provide me with US$100. That works out the be a forward hedge rate of AUD/USD 0.9545 (100/104.76). Of course the rate would be a little worse once I take out fees. This rate can be guaranteed whether the currency is 1.50 to 0.50 in 1 year because the USD amount is already known, and I have the AUD funds already organised.

I have zero currency risk with this structure because it is all set up day one. The only risk I have is CREDIT RISK. That is, whether you will actually deliver the USD$100 as contracted.

The real world
Obviously banks do not create liabilities and assets for every hedge. But they do run large hedge books, which usually (though not always) net-out to a very small number. But when the net number becomes large (say a one-off big FX forward for BHP etc), they will hold some foreign liability (in excess of foreign assets) to offset the risk. Either way, if the swap book is properly managed the issue is never about currency risk. It is always about credit risk.
That doesn't describe how FIs hedge risk through AUD bond issuance. It's a basic description of hedging currency risk for trade finance. If the FI sells the AUD bonds to a customer, say in the form of a foreign currency account, the customer carries the risk if AUD goes south, not the bank. Similarly with a fund. The investor carries the risk. Not the FI. Hedging risk in bonds issued in AUD is not a major concern for banks.

I can sense you were talking out your cake hole when you first mentioned this.
Edited by Terry, 18 Sep 2016, 10:17 AM.
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Jon Snow
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b_b
18 Sep 2016, 03:46 AM
Ok - so how to provide a currency hedge without exposing yourself to currency risk. Best to show by example, and for that we need some basic assumptions.

AUD/USD (Spot) 1.000 (parity)
Term of hedge: 1 year
US Interest rates: 5%
Australian Interest rates: 10%
Fees costs etc zero.

Now assume you have a business that makes widgets in Australia and sells to the US. Assume you just won an order to supply 100 widgets to the US for US$100. The problems is, it will take a year to manufacture the widgets and settle the order. And while its costs A$80 to produce the widgets, a drop in USD could wipe out profits when settlement takes place.

So I come along a guarantee the forward rate (a hedge contract). My guarantee rate is 0.9545. I can do this while taking zero currency risk. How?

Well I know you will received US$100 in one years time. So all I have to do is Borrow USD$95.23 today and use the proceeds to buy A$95.23 at spot. Why this amount? Because US interest rates are 5%, so in 12 months, my US loan will be US$100. Exactly the contracted amount you will received in 12 months.

Meanwhile, in 1 years time the AU$95.23 deposit will increase by 10% to 104.76. I am therefore prepared to deliver AUD$104.76 to you in 1 years time so long as you provide me with US$100. That works out the be a forward hedge rate of AUD/USD 0.9545 (100/104.76). Of course the rate would be a little worse once I take out fees. This rate can be guaranteed whether the currency is 1.50 to 0.50 in 1 year because the USD amount is already known, and I have the AUD funds already organised.

I have zero currency risk with this structure because it is all set up day one. The only risk I have is CREDIT RISK. That is, whether you will actually deliver the USD$100 as contracted.

The real world
Obviously banks do not create liabilities and assets for every hedge. But they do run large hedge books, which usually (though not always) net-out to a very small number. But when the net number becomes large (say a one-off big FX forward for BHP etc), they will hold some foreign liability (in excess of foreign assets) to offset the risk. Either way, if the swap book is properly managed the issue is never about currency risk. It is always about credit risk.

You forgot basis risk. To hedge basis risk you would need to enter into an IR swap, no?
Speak when you are angry and you will make the best speech you will ever regret.
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Jon Snow
18 Sep 2016, 11:45 AM

You forgot basis risk. To hedge basis risk you would need to enter into an IR swap, no?
Only if you borrowed and lent floating. But it is pretty easy for a large financial insto (ie a bank) to borrow and lend fixed to match the FX hedge settlement. Remember lending fixed is no different to buying a government bond with the desired maturity.

Edit: Now there is duration risk...but that is pretty small and the scheme of thing and will be more than covered by the bank fee / margin etc.
Edited by b_b, 18 Sep 2016, 06:14 PM.
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