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An "Interesting" Picture of the US Bond Markets

THIS IS THE MOST ALARMING PICTURE I HAVE SEEN IN THE FINANCIAL MARKETS SINCE SOME TIME.

The points to note are:

  1. 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.)
  2. This level is unprecedented.

Why Should We Be Worried:

  1. What information has led to the professionals building up this unprecedented position in such an accelerated fashion?
  2. What are the consequences of the unwinding of this position?
    1. 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.
    2. If it is an unorderly unwinding the bond yields start rising fast from the beginning of the unwinding.
  3. 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:

  1. 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!
  2. 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:

  1. Unwind leverage in the portfolio
  2. 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.
  3. Pare down exposure to aggressive equities.
  4. Hold investments that you intend to hold for the long term (at least 2 years) only.
  5. Temporarily move out of synthetic instruments (structured paper, hedge funds, OTC derivatives, Fund of Funds, etc)

 

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