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money down. It’s where cool calculation stands in stark contrast to sunshine pumping. People can talk all they want about how great Greek bonds are. If they’re really on board with the technocrats and think the EU is going to hold together as is, then long that 10Y Greek debt and short 10Y Bunds. The trade shows the risks of the status quo more clearly than anything else. The whole thing looks like picking up pennies in front of a steamroller. Spread divergence has fateful traps too. It needs faith that time will soon be on your side, and soon and the world’s tail risk killers will fail. On one side are hubris-riddled bureaucrats with a deep line of taxpayer credit to distort reality. It’s the force of history via out of sample mean reversion versus the hubris of man. Who says investment doesn’t have tragic plotlines? Tail Risk Killing and the Bubble World: Treasuries are not GGBs… Yet Central banker (and political stooge) socialization of financial system losses makes sovereign debt default concerns light up like a night in Vegas. So too, much fear of the “treasury bubble” popping. Treasury yields aren’t the only thing people should be worried about: almost every asset has a bubble valuation anymore. In many cases, the sovereign debt run-up is just a symptom of the problem, not the problem itself. The real problem is private sector debt creation in reverse. The tail risks associated with this is why Bernanke is pushing the money machine to the limit. He’s doing what he thinks will kill those tail risks. His perceived middle game is probably some Japanese variation… the tail is much worse. This generation is conditioned to living in a bubble because of all the leverage. So forget about “quality” and “fundamentals”, because they are so distorted the notions lack meaning. Nobody thinks a US treasury bond displays awesome fundamentals. This is not why you buy them. Treasuries are not a flight to quality at all. But when debt reduction is the prevailing wind, what really matters is liquidity. People sell quality assets because the higher mark allows them better loss cover. They ride out the storm in the most liquid instruments. Pricing of risk is completely altered when living in a bubble. Super easy monetary policy makes you desire what you should fear and fear what you should desire. Liquidity policies are designed to obscure insolvency and illiquidity up to the breaking point. Risk in a meltdown always looks like a “flight from the despised”, bubble or not. But in a bubble-world, it is really a flight from leverage. Assets with little leverage possess valuations that offer more than commensurate return in exchange for the risk. Such bottomed out assets (like sugar #11 not too long ago) are uncommon. With gobs of cheap money lifting all boats, nothing stays despised for long. A buying cheap and selling dear strategy has a high success rate.
The bubble world has lasted long enough to blind people to the alternative valuations that lie outside it. But the bubble world we live in is not irreversible. It is pretty unique from a historical standpoint. Bubbles pop. So it is wise to prepare for phase transitions, where non-stationarity makes the rules change as one goes, and liquidity becomes like a breath of air in a vacuum. The macro themes of unsustainable systemic backstops pitted against organic deterioration of economic conditions are telling signs of a reality shift. Jousting Windmills: Sovereign Debt as an Asset Class Sovereign debt markets are a good asset class to position macro trades that play off these themes. When spreads rise, it is a moment of clarity when risk is weighed realistically. When spreads explode it is the moment of panic at the top of the food chain. Government securities are somewhat like a bond and somewhat like equity; CDS has changed this little. It doesn’t obey default probability formulas the same way as other debt. For any debt instrument there is an interest rate beyond which debt service becomes unsustainable. What makes it equity-ish is that recovery rate assumptions are meaningless when bankruptcy is more than a little ambiguous. Thus the root problem is that government credit risk is not easy to quantify: it is the faith of people and leaders to sacrifice and honor their commitments. One country will find a way to pay service debt, and another will not under similar conditions. For existential reasons, a country like Latvia takes pains to keep the good graces of its creditors to the west. They’re scared of what history says about the guys on the east. Greece provides another, opposite example. Residual stuff like history and culture surely plays some role. Cultures can be rooted in the idea of the state as a civil entity, where the state is merely the custodian of laws, and does not seek to impose any preferred pattern of ends, but merely facilitate individuals to pursue their own ends. Other cultures view the state as a business: government is a manager of an enterprise that legislates standards that equalize people to some degree. These differences may matter in reflecting the scope of spending excesses, but at the same time be irrelevant in predicting taxpayer willingness to default. This is all running in the background before assessing credit risk even starts. Metrics like current account and external indebtedness and model outputs are mostly a confirmation of pre-conceived risk assessment. Measures like tax revenue forecasts and GDP projections are almost surely unrealistic. They don’t tame the noise in what underlies a cash-strapped nation’s faith and credit. Market Neutral Methods: Cointegration and Burning Witches A way to express a spread bet on government securities is through a pairs trade. Pair trading has a lot of different names depending on the assets used in construction. It is a market neutral strategy that depends on mean reversion. There are practical problems associated with any such pair trading construction. For
example, demands for margin cover, reducing carry cost, and keeping equity capital on board before things have ripened. There can also be model failure, or failure in trading period selection. Still, market neutrality is a good way to manage liquidity, but waiting on mean reversion can be a killer. Using quantitative methods is a way to rigorously find solutions to the issue of waiting. The rigor comes from statistical models developed from data in a training period and deployed in a trading period. These quantitative pairs trades have method problems too; the issue of training period selection is decisive. The point of such a model is to determine cointegration between non-stationary variables. Cointegration specifies a predictable relation, be it causal, or coincident within the training period. This relationship is then traded outside of sample. Choosing an appropriate time period for robust cointegration is hard, because the relationship is very sensitive on the sample data. Outside of sample, relationships can quickly break down. This problem is well understood by those who trade based on 60 day, 100 day, and 200 day moving averages. Selecting the appropriate timeframe is guesswork in both contexts. Macro trades require correct human judgment about the whether the model should incorporate data going back to, say, May 2009, 2000, or 1973. The appropriate mean, much less mean reversion, is unclear. Everyone knows correlations break. Cointegrations are no different. Even in lowleverage, high-frequency settings with small trading windows, it could be nothing more than randomness that makes pair trading work. It may not matter which of the pairs is shorted because noise dominates at micro-second increments. Even if our mean estimate is sufficient because we choose all available information, there are other troubles. Consider a continuous time series of Bible prices going all the way back to 1608. We have two pairs: prices in the struggling Jamestowne Settlement in Virginia and prices in Franz Buirmann’s witch-barbequed Koln. Is it really possible to play an arb where the conditions causing the desperation are fundamentally different? Or consider another example of Koln in 1430 (when Bibles were hand copied versus 1436 after the Guttenburg press was running. This is a classic bifurcation induced by technology. Difficulties aside, pairs trading is suited for macro trades exploiting a qualitative theme. As the world shifts from an easy liquidity, colored-by-noise framework, to a liquidity starved austerity, most models won’t provide much advantage. The sample data is too limited to arrive at meaningful cointegrating vectors when the regime totally changes. Relying on such models is far too conditioned on contemporary history, and not able to capture the jumps that things like monetization or IMF bailouts generate. These policy interventions make precision effectively impossible, and neither assessment nor calculation does much good in defining proper action. What really matters in the described phase transition is luck, intuition, and an ability to be resourceful and stubborn. Confidence comes from being broadly right. This is the human edge: the games of Mikhail Tal and Alexei Shirov show how some have sharply higher intuitive power in the face of complexity when others buckle under ambiguity.
Bureaucracies seldom have such an edge. Appointees like the central bankers and finance ministers don’t have more coolness under fire or resourcefulness than the average guy, and this is an investible thesis. In fact, because of the sheer scale of influence they exert, when panic strikes they make things worse. They suppress present tail risk, and in so doing create bigger future tail risks. One such qualitative theme is the limited intelligence and dubious quality of governance. This may be the macro theme Nassim Taleb has in mind when he talks about shorting treasuries. There are sharper instruments than treasury shorts to profit from stupid bureaucratic stubbornness. This is the House that Funk Built: EU Integrity or Fragmentation Belief in the EU staying intact is equivalent to govvie spread convergence. Collapse is equivalent to spread divergence. Anyone who shorts Bunds and longs Greek debt as a mean reverting pairs trade is counting on either of the two things: 1) Greek bond yields coming down, or 2) German bund yields blowing up. Although 1) is a joke, a German commitment to the EU makes scenario 2) likely. Germany’s stable economy and solid macroeconomic data could crater. It’s controlled fiscal deficit and efficient tax policies will buckle under commitments to other member nations. Their economy is the largest in Europe, but borrowing from the market will not be cheap going forward. Being on the hook for other nations’ default-like situations will magnify their credit risk. Mean reversion is at work in shorting PIIGS too, but it is reversion is to yields outside of the sample below. It implies spread divergence, not compression. Throughout the decade, there is massive convergence of yields and low implied risk premium. But there are deeper historical forces at work, expressed in the recent spread widening. Propping up the status quo won’t continue indefinitely. Voter refusal to subsidize an artificial spread compression is where the rubber hits the road.
Indeed, a trade on the spread explosion between GGBs and Bunds earlier this year was a masterstroke. Now risk assessment of Greek prospects is far more realistic now than a few months ago. Few will be shorting Greek bonds with spreads as they are. But Greek debt isn’t the only instrument to take a view on EU integrity. The chart shows some candidates for a spread trade on things going deeply wrong in Europe. Each bond carries has its own messed-up psychoses. Portugal too has a long way to go before accomplishing what is needed to put their house or banking system in order. Rising Greek internal tensions and resistance to public sector job cuts and strikes make it a time bomb. Internal stresses from Spain, Portugal, Ireland and others reduce the extent of fiscal assistance even as EU periphery problems poison the Austrian banking system. Ten year Portuguese bond spreads less than 3% over Bunds is not reflective of 9% of Portuguese banking assets coming from the ECB teat. It’s takes a real pile of crap to need the level of life support Greece has. It also tells you that Someone in the EU is invested in making the center hold.
Source: Goldman Sachs 9/2/2010 Funding Update
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