THE OTHER DARK SIDE

Starting a short position in US fixed-income

It will be a quick and simple one today.  Obviously the Chinese virus situation worsened over the weekend.  As Howard Marks so eloquently put it this morning on CNBC, "the market has gone from containment to contagion almost overnight."

As I wrote early last week, I had shifted to a short risk posture (TIME TO TAKE A SHOT AT THE DARK SIDE), but to be truthful, I am not sure what to do here.  I was long nasdaq volatility and with the spike in implied volatility, I have taken a fair amount of it off.  The index arbitrageur in me hates being long expensive options.  But that's not the subject of today's post.

What I would like to do is prepare you for a trade that is setting up beautifully.  As most of you are aware, I am ursus arctos horribilis when it comes to fixed-income.  Last week, as I got nervous about the flu situation, I rotated myself into a neutral delta long gamma bond position.  I must admit that I hedged every uptick a little too quickly as I can't even let my gamma run to the upside when it comes to bonds.  This was about as bullish of fixed-income that I ever get.

I am aware that the virus situation is extremely serious.  I know this has a chance of pushing us into a global recession.  Please don't send me any data about how the economy is heading off a cliff.  Yup.  I understand this is a definite possibility.  Why do you think I was short risk assets?  

However, I want to make one important point.  If there were no virus worries, the U.S. bond market would be many, many handles lower.  Why?  The American economy was screaming hot before the virus popped up.

Have a look at this chart of the Citibank Economic Surprise Index:

This index measures how much economic releases are beating or missing economists' estimates.  Over the past two months, the American economy has been blowing the doors off of expectations.

Usually this would cause the bond market to back up hard, but worries about the virus caused a monster flight-to-safety bid into U.S. treasuries:

This was a gigantic move considering the underlying strength in the American economy.  And it's not only economic indicators that are exceeding expectations, but we are seeing signs that inflation is finally starting to bubble up.  All in all, absent the flu developments, bonds would be choking on all this economic data.  As traders we need to consider the possibility the flu ends up being not as catastrophic as the market is currently discounting.  If that happens, where do bonds go?  And how do you discount the different possibilities?

A younger brasher Macrotourist might have stood in here and proclaimed this bond rally done.  I used to make bold calls like that, and I have the stubby-missing-fingers hands to prove it.  Knife catching is hard.  And not only that, it's way more stressful than it needs to be.

Therefore I am starting to pick away by buying fixed-income puts.  I am going slow, and fully expect it to go against me as I establish my position.

However, a global recession is increasingly being priced into fixed-income markets, and although I understand that outcome is a decent possibility, I suspect the market will be shocked at the amount of stimulus headed down the pike.  Be careful in assuming that a coordinated monetary/fiscal response is friendly to the long-end of the bond market.  The risk reward is beginning to favour fixed-income trades from the dark side.  I dipped my toe in this morning, and I will expand on my reasons in the coming days.  

Hopefully I won't also find ways to lose toes as well as my fingers, but I think this is one of the best risk-reward opportunities out there right now.

Thanks for reading,  
Kevin Muir  
the MacroTourist