Why I Sold the Long End

My bond strategy has always had a position in TLT until last week.  TLT, composed of long Treasuries. is a hedge against deflation, and has made money for my clients.

I changed last week because of significant disagreements at the Fed regarding the duration of QE, and also the selloff in the long end breaking my price drop limits.  Also, it is worthy of note that each Fed intervention is leading to smaller results.  In the process, I made more money from my credit-sensitive investments than I lost from TLT.

With stocks, I am not a technician or an active trader.  With bonds, I am both.  Why?

Bonds are more determinate than stocks and the tradeoffs are clearer.  Bonds are promises to pay under certain conditions.  Those conditions can be analyzed more readily than the open-ended conditions of stocks.

At this point in time, I am taking limited domestic credit risks, and taking larger risks in the emerging markets, where economic policy is more orthodox then it is here.

But beyond that, I have pulled in my horns, and have reduced interest rate risk.  If I see opportunities, I will act on them, but I am taking far less risk than previously.

3 Comments

  • Greg says:

    David — just curious as to your thoughts on “risk parity” portfolios?

    While I have read all the sales brochures on RP, I can’t help but notice that their asset allocation tends to lean heavily toward bonds — and by necessity (small size of other bond markets), that means they lean heavily toward treasuries and MBS.

    If your thesis on bonds is correct (I tend to agree) — what happens to all these “experts” who have been selling levered fixed income as alpha?

    No matter what silly rhetoric he gives in his speeches, a lame politician like Bernanke is not in a position to normalize interest rates — read my lips, sex with my intern, WMD, hope and change, yadda yadda yadda. Uncle Sam is in very serious trouble even if interest rates do not normalize.

    At the same time, longer term interest rates can’t go much lower. They are already lower than CPI, and much lower than the true cost of living. Lame polticians (Bernanke, Obama, and Congress) have been ignoring the effect of zero interest rates on pensions and those on fixed incomes for too long already. Every month the crooks extend QE???, the public unions pensions suffer (never mind all of us in the real world). Even if one thinks QE was a good idea — the pain / costs cannot be ignored forever.

    That makes bonds a lot more risky — their duration is much higher, magnifying every stupid move the FOMC makes. They can’t artificially lower rates without causing massive demographic problems, they can’t allow rates to normalize without admitting the government is bankrupt, and they can’t leave rates where they are without admitting pensions are insolvent.

    If the bond bull market is over, risk Parity portfolios have to reduce their bond allocations very very quickly. And most of them are levered in bonds — one can’t get 15% reported returns with any combination of S&P (6% TRR) and bonds (3% yield), unless you lever up big.

    How does something the size of Bridgewater or PIMCO or Blackrock exit the bond market gracefully? I won’t even ask how something the size of the Fed could exit — they obviously can not.

    Who is going to have to take massive losses?

  • Greg says:

    Sorry, I think I phrased my question poorly. You are preaching to the choir on risk parity (at least IMHO).

    I remember hearing about LTCM years ago — they were such amazing geniuses that somehow they really could turn lead into gold. Even though John Merriwether is a really smart guy, it was too good to be true. When Sandy Weill/Travelers/remains of Solomon Bros decided to abruptly exit the levered off-the-run / current Treasury trade (and the levered Russian debt trade) … the jig was soon up for everyone super levered in the same trades. “Suddenly” LTCM had massive losses (not to mention the losses at the Travelers/Solly and many other prop desks). Turned out that they could not produce double digit returns out of single digit investments.

    When the alchemists that took lots of toxic waste (CDOs, subprime, etc) started having temporary liquidity problems — “suddenly” a new class of super geniuses was unable to produce the double digit returns out of mortgages that paid single digit returns.

    I see similarities today with the geniuses at Bridgewater / Gundlach / etc. Dalio and Gundlach are clearly really smart guys, but they still put their pants on one leg at a time. Even if one doesn’t have all the details of their portfolios — they are obviously very very levered to produce double digit returns out of a market barely growing.

    We all know the “deflation” trade is rubbish — there is no deflation. CPI is rigged to show low numbers, and not even CPI is showing any sustained deflation. We are all front running the stupid twit running the FOMC.

    So the question now is: who is going to show a “sudden” catastrophic loss? We all know there was/is nothing “sudden” about any of these stories. Portfolio managers (a few not so smart, but many of them are smart) have over-promised … and they are using massive leverage to create the illusion of turning lead into gold.

    I am trying to figure out who is going to be left holding the bag when the “magic” of front running the FOMC stops working.

    Wondering if you have any thoughts on this, and if you are willing to share them?