Widowmakers Everywhere: 3% is the New 5%

Speed Read

  • Implied vol and implied vol products on duration sovereigns have matched or breached historic lows.

  • Implied vol is so cheap it is hard to resist going long as a semi-static hedge or contrarian bet.

  • Implied vol on govvies is just a variant widowmaker trade.

  • True sovereigns can and do display extremely low realized and implied volatility.

  • Govvies have deep macro support. The features of a true sovereign make them admirably able to attract bid from other asset classes.

  • One day, some lucky pothead is going to be short JGBs and Bunds and the long bond at exactly the right time. He or she will surely make a killing. He or she will be lauded as the offspring of a pirate and an angel. But they are really just lucky.

Implied vol on the long bond has reached lows not seen since 2007. 1Y30Y swaption vol has reached all-time lows. It’s tempting to think of this as a cheap proxy for short duration, short treasuries, short govvies. The features of a true sovereign make them admirably able to attract bid from other asset classes.

That said, the set-up certainly looks attractive.

ZB_F: 30Y bond vol is at 10 year lows...

1Y30Y swaption vol is at all-time lows...

Don’t believe that this is all complacency. What conviction buyers ignore is the cost of maintaining the hedging position can drive the payoff of the trade negative. It’s just another widowmaker. Here's why.

Definition: A widowmaker is a semi-static short position on a true sovereign that functions as a contrarian bet which generates small losses with high probability and large gains with low probability.

Attributes of true sovereigns:

True sovereigns do not default.

True sovereigns have zero default risk. Credit fundamentals are irrelevant when this condition holds. A true sovereign can guarantee investors their coupon and original capital upon redemption. This is because a true sovereign issues debt in their own currency; has full taxing power over their population; and in a real pinch, can create arbitrary quantities of its own currency via central banks or similar institutions.

True sovereign yields are determined by the outlook on interest rates and inflation levels.

High debt to GDP ratios, deficits, and excessive supply does not determine true sovereign yields. Markets cannot impose externally timetables for fiscal retrenchment on true sovereigns until interest rates and inflation levels reach critical mass.

Implied vol on a true sovereign is cheap for a reason: True sovereigns are very, very good at attracting new buyers. Matt King in July 2018 put together a great chart showing this. Even as the Fed was a net seller of treasuries and issuance increased, a variety of investors purchased treasuries. Credit in contrast struggled for buyers even with flat issuance. The implication is that treasury vol rarely explodes like VIX does when equity breaks down.

Current vol levels do signal complacency about the inflation expectations and the path of policy rate hikes. But there are strong macro reasons for this complacency.

On a deep level, the financial and economic interconnections have yet to recover from the financial crisis. M2 velocity makes this clear. This could be caused by bank capital buffer requirements driving cash accumulation. It could be a structural feature of the economy where lower income people have high debt and low asset levels and higher income people have low debt and asset rich. Whichever asymmetry explains this, inflation is an extreme tail risk.

Also, credit creation is rolling over and dragging housing prices down with it. There is no way that policy rates will continue an upward trajectory if this becomes a sustained trend.

Instead of a Widowmaker trade, there is actually a strong case to be made for taking conformist trades: bets with payoff profiles that generate small gains with high probability and large losses with low probability. Buying the long bond is the conformist trade du jour.

One day, some lucky pothead is going to short JGBs and Bunds and the long bond at exactly the right time. He or she will surely make a killing. He or she will be lauded as the offspring of a pirate and an angel. As for the rest of the money-runners that ignored the fact that a central bank has govvies’ back, the cost of the trade turned it into a dumpster fire as they stare into the bongwater.


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