THIS IS THE MOST ALARMING PICTURE I HAVE SEEN IN THE FINANCIAL MARKETS SINCE SOME TIME.
The points to note are:
- The current Long "Open" Interest in 10-year US treasury bond is greater than SIX Standard Deviations (12 SIGMA)!!!!!!! (The odds of a 6-Sigma event are one in 500 million or 1.37 million years, so it will be exponentially higher for a 12 Sigma event.)
- This level is unprecedented.
Why Should We Be Worried:
- What information has led to the professionals building up this unprecedented position in such an accelerated fashion?
- What are the consequences of the unwinding of this position?
- If it is an orderly unwinding the bond yields should be at the current levels or lower for some time from the beginning of the unwinding.
- If it is an unorderly unwinding the bond yields start rising fast from the beginning of the unwinding.
- Either way, the important consideration is the consequences of this unwinding on the other asset classes (please note that the bond markets are 4 times the size of the equity markets!!) and the dominoes effect on other asset classes and participants.
Why I Could Be Wrong:
- Notwithstanding the odds of a 6-sigma event, we have seen a level of 6-sigma three times in the past two years and there have been no major dislocations in the markets!
- The market size has grown and the liquidity is very much higher with bigger and "sophisticated" participants. The game is probably just being escalated to a higher level.
Some of the defensive steps:
- Unwind leverage in the portfolio
- Get out of long-dated debt preferably into the highest quality / sovereign short-term debt. Do not hold paper you do not intend to hold to maturity.
- Pare down exposure to aggressive equities.
- Hold investments that you intend to hold for the long term (at least 2 years) only.
- Temporarily move out of synthetic instruments (structured paper, hedge funds, OTC derivatives, Fund of Funds, etc)
