Short the Big Short

For many, many years, the widowmaker trade of global markets was to short Japanese bonds. JGBs were considered vulnerable to a selloff for decades owing to massive budget deficits and notions of rebounding inflation. It never happened.

There were occasional wins. But overall it was a one-way bet to nowhere:

The same dynamics are emerging around US treasuries and for similar reasons:

Michael Burry, whose huge, wildly profitable bets against the housing bubble were made famous in “The Big Short,” is wagering that long-term U.S. Treasuries will fall.

His Scion Asset Management held $280 million of puts on the iShares 20+ Year Treasury Bond ETF at the end of June, according to a regulatory filing released this week, an increase from $172 million three months earlier.

The options contracts would make money if TLT, as the exchange-traded fund is known, falls as Treasury yields go up — something that hasn’t happened lately as fear of the delta variant drives investors into Treasuries.

Everybody on Wall St that I read is short Treasuries as the Fed taper rolls in. I am far more skeptical for three main reasons: the inventory cycle, China and the US fiscal cliff.

The post-COVID inventory cycle is rapidly normalising outside of cars. This means the impact of pent-up demand on industry is fading and we still see steep downsides in PMIs across H2.

Second, China is still tightening and has its eye on much lower commodity prices. In my experience, US analysts significantly underestimate the impact of China on US inflation.

Third, the fiscal cliff that is looming is enormous. It will be offset by reopening but growth levels will also normalise quickly as the fiscal impulse craters.

If you wish, you can add Delta but its impact is pretty small.

Over the remainder of 2021, the US economy is going to keep slowing, inflation fall and 2022 shape as a year of deep industrial deflation as base effects and much lower commodity prices sweep through global production.

If the Fed tapers now, it will make all of this very much worse with a higher DXY. Indeed, if it tapers, we’re odds-on for a global growth shock centred on commodities and EMs.

This is not an outlook for a sustained rise in US Treasuries even if we see a short-term backup in yields.

Recall Viktor Schvets:

Neither demographics, debt nor productivity will be differentiators

One of the most consistent macro themes over the last two decades was that disinflation and deficient demand that afflicted Japan since the early’90s or Eurozone since’08, cannot occur in the US. There are five arguments against Japanification of the US: 1.Radically different demographics; 2.Significant differences in debt overhang; 3. Differences in productivity trends; 4. Role of private vs public sectors; and 5. Labour flexibility and innovation impulse. While each argument contains a grain of truth, they are insufficient to negate experience of Japan or Eurozone. On the contrary, similarities are far greater.

1. At the peak of deflation in the ’90s-early’00s, Japan’s demographics were similar to where the US is today and by 2030, US is likely to approach Japan’s demographics a decade ago. The same applies to Eurozone. US will still enjoy better demographics, but differences are narrowing rapidly, and hence, it is unlikely to be a dealbreaker.

2. While massive debt overhang that Japan endured in the’90s was unusual; now it is common. In 1990, Japan’s debt to GDP was ~4x while the US was at~2x. Today, Japan’s debt burden is~6 x GDP while the US is touching 4x (~6x if adding unfunded liabilities), with public sector in the US at ~130% of GDP vs Japan’s state debt below 100% in late ’90s. Eurozone’s debt is now only slightly ahead of the US, and lower in the public sector. 3.US and Eurozone are essentially mirroring Japan’s expansion of base money through’90s-early’00s, with a pace stronger than Japan was then prepared to accept. Hence, collapse in the US velocity of money has occurred at a greater speed than in Japan or Eurozone.

4.The gap in role of the state is narrowing, with the US raising its public spending at a far stronger clip. While it can be construed as both positive and negative, this argument for slower growth (state dominance) is no longer relevant. 5.While US remains the innovation leader, Japan and EU have a greater share of patents while their R&D is approximating or exceeding US and labour flexibility is eroding. 6.Productivity (TFP) trends in the US are nolonger exceptional. Over the last decade, US TFP has slowed to ~0.3-0.4% (below Germany and Japan).

There do not appear to be strong reasons why US will not follow Japan unless there is a fundamental shift in the natureof the economy, and even then, it is not clear what that change might be. If deficits were the answer, Japan has done more of that than anyone else. One might argue that Krugman’s retort about the need to be‘credibly irresponsible’ is more attuned with the US than Japan of’90s, but since ’12, Eurozone has been just as ‘irresponsible’. Fiscal-monetary fusion could be helpful but Japan has been doing it for two decades, with BoJ now sitting on 52% of JGBs. It seems that what we describe as a Fujiwara effect (merger of Information Age and financialization) is so powerful, the best fiscal, monetary and social policies can do is to soften disinflationary backdrop, implying that over the LT, rates are unlikely to rise, and the bond market is far from ‘dead’. At the same time, concern that USD is debased will be just as wrong as earlier angst about collapsing Yen. Equities are harder, but as long as CBs have ability to corral vols, CoE will remain contained and more likely fall over time. How does it all end? It does not, as the world adapts.

At this juncture, Fed taper is a policy error leading to lower yields not higher.

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