Black Swan Insights

Showing posts with label finance. Show all posts

JP Morgan Says Not To Worry About Surging Bond Prices

JP Morgan is out with a report telling investors not to worry about surging bond prices and that they do not necessarily mean we are entering a deflationary spiral as some have postulated. Looking back at prior economic cycles, JP Morgan notes that bond yields often bottom out approximately 2.5 years after the end of a recession. So the current rise in price of the 10-year Treasury is not completely unexpected and is simply following the pattern from previous recoveries. The firm also says that the two primary catalysts for the recent rise in bond prices are a decrease in inflation expectations and record buying of US bonds by US households. The current 5-year break-even rate on bonds is 1.3%, down from around 2% reached backed in June. Furthermore, US household purchases of treasuries has surged 46% year over year in Q1 2010. In fact, households are the second largest holder of US treasuries, ahead of Japan and only $100 billion behind China. If that was not enough to arrest deflationary concerns, JP Morgan goes on to mention that the strong resiliency of commodity prices indicates that deflation is a remote possibility at this point. I agree, oil at 75, copper at 3.30, and gold at 1238 hardly make sense if we are entering a deflationary period. The deflation scare mongering is just a ploy by central bankers to print more money. Below is a chart which shows the 10-year Treasury over the last 35 years.

Here is the full report from JP Morgan:

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The Yen Carry Trade: Are you feeling lucky?

What if I told you there was a trade where you could earn 20-40% annually and had a high success rate. The only downside is that it occasionally collapses and completely wipes you out. Would you consider this trade? Welcome to the carry trade.

The carry trade is relatively straightforward--you purchase a high yield currency and short a low yielding currency. For example AUD/JPY. Australia has high interest rates compared to Japan. Currently Australia's interest rates are at 4.00% while in Japan is at 0.10% making for a 3.9% difference. Theoretically you could buy 100,000AUD/JPY and make an easy $3,900 or 3.9% annually. That is pretty good considering US interest rates are at 0-0.25%. Now what if I told you that if you use leverage say 10-1(forex dealers give away leverage like candy) you could earn $39,000 or 39% per annum. You are probably salivating at the opportunity right. The best part of this trade is that AUD/JPY does not even have to move up for you to make money (even though that would be nice). It could simply remain flat and you still get your 39%. This seems like free money doesn't it?

But what are the risks?

Because this is a leveraged position your greatest risk is that AUD/JPY could decline from say 83 to 74. When you are using 10-1 leverage you will lose your entire investment if AUD/JPY declines by 10% or more (unless you are willing to put up more margin). However carry trade supporters note that this only happens a few times a decade. On most days you will win and get to collect your interest. This is what makes the carry trade so desirable and dangerous. Statistically you will win but when the trade blows up, you expose yourself to huge tail risk.

The Yen can surge 10% very quickly during market crisis like the Asian financial crisis. In one famous week in October 1998 USD/JPY fell (yen surged) from 136 to 111. We also saw a dramatic rise in the yen in late 2008 with AUD/JPY falling from over 100 in July 2008 to 55 by December 2008. Anyone who was long the carry trade got destroyed.

Conclusion

Anyone contemplating the carry trade needs to be aware of the perils of such a strategy. Yes, you can make good money during normal market conditions but you always know in the back of your mind that it will eventually collapse (just ask Julian Robertson of Tiger management who lost $2 billion overnight). The only question is when and more importantly will you be able to get out. If you still think this is a great trade make sure you put on the trade during an economic expansion with low volatility. In my opinion the benefits do not outweigh the risk of 100% capital loss.

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Market Thoughts 3/23/2010 Up, Up, and Away

All major indices were higher and recording 52-week highs. Oil and gold were higher along with the dollar index. Volume was fine but not spectacular. I am really glad the Federal Reserve outlawed down days in the market (Federal Reserve Board Directive 88907621) because it was so depressing and inconvenient for an economic rebound. I always considered the question: Can the market (tail) wag the economy (dog)? It sure looks like it can. All you need to do is engineer a stock market recovery and presto--banks can issue 100's of billions in equity. Is it really that easy?

Anyways, the only fools of the day were the shorts (sign me up) and the winners anyone who is long any asset class (except treasuries). Even the dog of the energy market natural gas was up a little (good for my position). Call me ignorant but I find this type of market difficult. I do not like markets that go straight up because I always fear the downside (that line of reasoning saved me from 2008 massacre). It is almost impossible to run a balanced trade book because you want to kill yourself for shorting anything.

The only thing I will say that might show a negative divergence in the markets is the relative weakness of some key commodities (Oil,Gold,Copper) and commodity related stocks like FCX,APA,BTU,X, etc. All of these have not made new highs along with the general markets. Does this mean anything? Normally it would but we are not in normal times. That said this market is egregiously overbought I am not establishing any new long positions. Still maintaining oil short and May puts on Owens-Illinois. But will not be including any other shorts.

Black Swan Insights

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