Today’s post will be self evident for many, but it is an important topic, and I know that I have expanded my knowledge in researching it, so I urge you to press on.
As most of you are aware, I am a big long term fixed income bear. But my bearishness sometimes clouds my thinking, and I try my best to seek the opposing view. So although I disagree with deflationists like Lacy Hunt, I go out of my way to listen to their views.
One of those bond bulls who has kept me honest is former head of JPM’s global macro division, Alex Gurevich. I kind of laugh because it seems like every economic scenario Alex dreams up, it always concludes with a recommendation for a long position in US fixed income. And yeah, I guess he could probably chuckle right back at me how I see inflation around every corner, but that’s not today’s topic of discussion.
What I want to explore today is Alex’s extensive use of total return charts. He is one of the best at stressing that total returns charts are essential when it comes to making long term macro investment decisions. Too many traders rely solely on nominal price charts. They stare at the US 10 year yield, and if the yield is unchanged over the course of a year, they assume the trade has gone nowhere. But that’s not the case. The reality is that during that period, an investor who held a position in US 10 year government bonds was earning the yield (and it’s even a little more complicated than that because during that time, the investor’s 10 year bond has become a 9 year bond, but you get the idea).
This oversight to take into account carry happens all the time. Whether it is the stock trader who fails to account for the dividend yield on the index, or the natural gas trader who talks about the change in the spot price without realizing that the shape of the futures curve greatly affects his/her ability to profit from this change.
And I have to give Alex credit because when he talks about his favourite position, he always stresses that you need to look at the roll adjusted price of US treasury bond futures. But what does he mean with that?
Let’s have a look at the US long bond future.
Currently the near month contract is trading at 154 16/32nds. But look at the December contract, it is trading at 153 12/32nds.
Let’s assume the price of the bond is unchanged over the next couple of months. During that time, the December future will have to rise to converge with the price of the September future today. That pickup of 36/32nds represents the carry. (Now it is not quite this simple as there are sometimes changes in cheapest to deliver bond between the contracts months, but for the sake of argument, let’s just ignore that possiblity.) Technically this pickup is the difference in value between short term funding and the yield on the underlying long bond.
In an environment with a positively sloped yield curve, this carry will always be positive. Therefore the trader who is long bond futures, and continually rolls them each quarter, is earning this carry.
The problem that arises is that most traders look at charts that simply ignore this fact. When a new contract takes over as lead month, they simply flip over to the new contract.
Let’s have a look at how much this can affect the return.
Here is our US long bond future, with the lead contract price action as reported by the exchange, since the beginning of 2016.
I want to repeat, these are the actual prices from the exchange. But there are a half dozen days when the contract month is advanced to the next month, and the chart shows a loss on that day that does not really exist. In reality, the trader who was long would be selling one month and rebuying the new contract month at a lower price.
If you account for those days by adjusting the chart, it actually should look something like this.
Whereas the unadjusted chart showed an opening price of 155 and a closing price of 155, this new chart shows an opening price closer to 145.
The latest contract month price action will be the same, but all the previous months were adjusted to account for the roll.
What does this mean in terms of returns?
With no adjustment the return is basically zero.
But with roll accounted for, the return climbs to 5%.
This carry affects many different markets. It is one of the main reasons that VXX continually drips lower. It is the opposite situation of the long bond. Instead of the farther VIX contract months trading at a lower price, they instead trade at a dramatically higher price. The trader who owns VXX is paying the carry instead of earning it.
All of this was not new to me. Years of pricing and trading stock index futures made me acutely aware of the complexities of the various forms of carry.
But I must admit, like a mope I just accepted the charts that Bloomberg spit out at me. So when I brought up the US lond bond future using the US1 Comdty function, I knew that it represented the actual prices and just tried to mentally adjust for the carry.
Then I saw a tweet from super nice guy, and a terrific twitter resource, George Pearkes of Bespoke Investments. He shouted out about a new high in a roll adjusted future contract. I DM’d him and asked if he knew how to adjust my Bloomberg. George is a little bit of guru, so I shouldn’t really have been surprised when he immediately responded back with instructions. This seems simple, but I wasn’t aware of it, and I am like your annoying brother-in-law who has adopted a paleo diet, and is now overcompensating by spreading the word like gospel.
Regardless, here it goes.
Type GFUT GO. Then proceed to tab 93) Generic Rolls. Change the “adjust” box from “none” to “ratio.”
Hit Save, and you’re done.
And I didn’t mean for this to turn into a Bloomberg lesson, but I thought it was important to understand how carry affects returns. Be careful when you are using unadjusted continuous futures charts. Often they don’t represent the returns you will achieve holding a long term position.
Just a quick recap of the German bund trading going into the weekend. With yesterday’s dovish comments by ECB President Draghi, we have retraced right back to the recent breakout in yields.
Will the support in yields (resistance in price) hold? I am not sure.
Bund volatility is dragging along the bottom like a fishing lure with too many weights, so I am taking this opportunity to buy a little gamma. The bund yield will either bounce, or crack hard lower. I suspect bund trading won’t suffer from summer doldrums anytime soon.
And as for my favourite trade, shorting bunds and going long US treasuries, it is taking a pause.
It’s had a good move, down from 240 to 175, so maybe a rest is in order.