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October 09, 2006

An "Interesting" Picture of the US Bond Markets
by Pinank Mehta

THIS IS THE MOST ALARMING PICTURE I HAVE SEEN IN THE FINANCIAL MARKETS SINCE SOME TIME.

The points to note are:

1. The current Long "Open" Interest in 10-year US treasury bond is greater than SIX Standard Deviations (12 SIGMA)!!!!!!! (The odds of a 6-Sigma event are one in 500 million or 1.37 million years, so it will be exponentially higher for a 12 Sigma event.)
2. This level is unprecedented.

Why Should We Be Worried:

1. What information has led to the professionals building up this unprecedented position in such an accelerated fashion?
2. What are the consequences of the unwinding of this position?
1. If it is an orderly unwinding the bond yields should be at the current levels or lower for some time from the beginning of the unwinding.
2. If it is an unorderly unwinding the bond yields start rising fast from the beginning of the unwinding.
3. Either way, the important consideration is the consequences of this unwinding on the other asset classes (please note that the bond markets are 4 times the size of the equity markets!!) and the dominoes effect on other asset classes and participants.

Why I Could Be Wrong:

1. Notwithstanding the odds of a 6-sigma event, we have seen a level of 6-sigma three times in the past two years and there have been no major dislocations in the markets!
2. The market size has grown and the liquidity is very much higher with bigger and "sophisticated" participants. The game is probably just being escalated to a higher level.

Some of the defensive steps:

1. Unwind leverage in the portfolio
2. Get out of long-dated debt preferably into the highest quality / sovereign short-term debt. Do not hold paper you do not intend to hold to maturity.
3. Pare down exposure to aggressive equities.
4. Hold investments that you intend to hold for the long term (at least 2 years) only.
5. Temporarily move out of synthetic instruments (structured paper, hedge funds, OTC derivatives, Fund of Funds, etc)

Pinank Mehta
Metier Capital Management Pvt. Ltd.

Pinank Mehta is a director with Metier Capital Management Pvt. Ltd. He can be contacted at metier@mtnl.net.in

Metier Capital Management Pvt. Ltd. is not a registered advisory service and does not give investment advice. Our comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While we believe our statements to be true, they always depend on the reliability of our own credible sources. We recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you to confirm the facts on your own before making important investment commitments. This report does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The securities discussed in this report may not be suitable for all investors. Metier Capital Management Pvt. Ltd. recommends that investors independently evaluate particular investments and strategies. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives.

Copyright © 2006 Pinank Mehta

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