If You Short These Bonds, You’ll Make A Killing

Has the market learned to shrug off central banks?

We doubt it but today’s reaction to the EcB provides some semblance of hope. Still there’s a palpable degree of skepticism. Here’s our favorite, Bloomberg’s Richard Breslow:

“Others focus on the disruptive rather than liquidity enhancing activities of high frequency trading. Electronic dealing, both single and multi-dealer platforms, may have improved price discovery at the expense of liquidity on transactions in large amounts. And may have caused divergence from best practices, on both sides of the trade.”

“But I think the overlooked reality in today’s global trading environment is that, put simply, foreign exchange has just been harder to trade than other asset classes.”

Right. Which is a problem. Why? Because we’re in the midst of a global currency war. The asset class most sensitive to that can’t be a slave to machines. Otherwise you get results like this:

(Charts: Citi)

And you’ll also get VaR shocks, That sounds like an esoteric concept but it’s actually not. When vol is low, funds can lever up because it’s a calculus between vol and risk. When central banks compress vol, it causes these funds to lever up. When vol spikes, they have to lever down, and that causes turbulence (see last year’s bund shock). So what happens when FX turmoil returns?

Well, this, according to BOJ board member Takehiro Sato:

“He concluded by saying that from financial institutions' recent move to purchase super-long-term bonds in pursuit of tiny positive yield, "I detect a vulnerability similar to that seen before the so-called VaR (Value at Risk) shock in 2003."

Right. And that’s what’s going to happen. Not only in Japan, but in Germany too. We don’t make trade recos, but if you short these bonds and have the funds to be patient, you’ll make a killing.

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