By Kevin Muir of the Macro Tourist
It’s tough to be a hedge fund manager these days. The investing community can flip from treating you like a super-guru whose every word is gospel, to a complete bum, almost overnight. Last week, with news that famed hedge fund manager Hugh Hendry was closing his macro hedge fund firm, Eclectica Asset Management, they turned on poor Hugh like a pack of rabid dogs. Thank goodness for decent individuals like Santiago Capital’s, Brent Johnson, who reminded us of the enormous difficulties in this game we choose to play. Well said Brent, well said.
I have always enjoyed listening to Hugh. And even though I didn’t agree with every trade, he made you think. It’s been a couple of hundred years since my great, great Grandfather, Duncan Muir left Scotland for Canada, but his genes must still course through my veins, as I often found myself thoroughly enjoying Hugh’s rascal-like Scottish demeanor as he poked his finger in the eye of conventional thinking.
And you have to give Hugh credit for facing his fund’s closing head-on. He could have quietly slipped into the sunset. But instead, Hugh laid out his investing soul for all to see. And Hugh didn’t just do it with a farewell letter, but rather embarked on a short media blitz that I am sure he regretted at times.
The topic of today’s post is Hugh’s parting trade idea. When the Bloomberg interviewer posed the idea of a mythical 1 billion sterling client with the patience of a saint, and asked Hendry what he would do with the money, Hugh responded the following:
“…the most distorted asset class in the world is the 2-year German bond, or the Schatz as it is named. I’d be short that. People are willing to lose 75 basis points a year for security. You know what? You don’t need that security.”
Is shorting the Schatz really the best trade on the board? Will Hendry ultimately be proven correct?
Let’s have a look at some charts.
First, here is the 2-year German yield over the past decade.
Yup, pretty bloody stupid. Paying the German government 69 basis points for the privilege of allowing them to hold your money over the next two years might go down as one of the dumbest trades in the history of finance. Negative rates are one of the great perversions of modern monetary theory. They should have been avoided at all cost, but instead they were embraced throughout Europe and Japan.
But just because something is asinine, doesn’t mean that shorting it is wise.
When I first started writing this piece, I expected to find that Hendry had picked the wrong maturity German bund to short. I thought the 2-year Schatz was trading at levels that simply reflected expectations for an “on hold” ECB for the next two years. Much to my surprise, I was wrong.
The German overnight deposit rate is trading at negative 40 basis points. That means an investor can earn an extra 29 basis points by rolling their funds at the extreme front of the curve (depositing with the ECB) versus the two year schatz, as long as the ECB does not lower that rate even further. The front end of the German yield curve has a peculiar inversion.
Hendry is right that investors are paying for the safety of investing in German Schatz, but he took liberties when he claimed the entire negative rate represented a reach for safety. It’s really the extra negative yield versus the negative 40 overnight rate that represents the richness of the two-year.
Well, that’s assuming the ECB does not go even further negative. But, given the stress that negative yields have caused on pension funds, insurance companies, and savers, it seems like a safe bet the ECB will only lower rates in an absolute disaster (and even then, I would argue they would be better off doing more QE than lowering the rate.)
I am a big German bund bear, but I have been concentrating my efforts at the longer end of the curve. Hendry has opened my eyes to the possibility of shorting the front end as well.
The real question is what will the coming interest rate moves in the German curve look like. You can short 7 Two-year Schatz futures to achieve the same Basis Point Value as the 10 year Bund future.
So will a lifting of the German bund safety trade make the 2-year rise more basis points than the 10-year bund? I don’t know, but I am inclined to say that Hendry got his last trade slightly wrong.
The most overpriced asset is not German two-year Schatz at minus 69 bps, but instead German bunds at positive 45 bps. If you believe that the ECB will hit their inflation target come hell or high water, why on earth would you invest in a 10-year bund, locking in a negative 155 basis point loss in real terms? Yeah, eventually the two-year will rip higher when the ECB takes their foot off the gas, but I suspect the yield curve will only get steeper in the years to come. If the two-year shits the bed, the ten-year destruction will be epic.
For the short two-year to be a better trade, you would have to assume the ECB would be relatively hawkish, causing a bear flattener. ECB hawkish? They are only going to raise rates once inflation is screaming. Draghi will be late, not the other way round. Therefore, it makes more sense to play the long end of the curve.
Now, I don’t want to nitpick Hugh’s argument too closely. After all, he has already taken enough flack, but most importantly, we are on the same page. The whole German bund curve is a screaming sell.
At the end of the day, I am hoping we are both correct. A’ richt Hugh, let’s git this german bund bear merkat gaun!
Gundlach’s still waiting for his 400%
Speaking of hedge fund gurus, do you remember all the excitement about DoubleLine’s Jeffrey Gundlach’s “if I don’t make 400% on my S&P 500 puts I will be disappointed” bearish prediction on August 8th? This was around the same time as a bunch of other billionaire bears were getting negative.
Since then, spooz are up and more importantly, implied volatility is way lower.
I hate tagging along with hedgies trades in the heat of the moment. Often you are competing with a bunch of other mopes, and most importantly, the hedgies are already positioned in the direction of their tout, so the most likely outcome is a snap back the other way once the excitement wears off.
And that’s exactly what happened this time.
Yet, sometimes the trades make sense, the timing just sucks.
So even though I am a long-term stock bull, I think it makes sense to take a dark side stab through a long position in equity index puts. Vol is cheap, the bears are busy licking their wounds, and the bulls seem a little overconfident.
To me, the risk reward for buying some protection in here makes sense. I am buying December 2500/2300 vertical put spreads, with the full knowledge there is a good chance they will be dust. But you don’t buy your insurance when everyone is warning about fires. You buy it when everyone has forgotten… What’s that expression? Buy your straw hats in the winter.