Thursday, December 12, 2013

30yr UST Auction Post-Mortem

Today the treasury sold 13bln 30yr bonds (re-opened the Nov-2043 issue).

After yesterdays fireworks following the weak 10yr auction, tensions were high going into today's 30yr bond auction.  Going into the auction, the 30yr bond had been outperforming on the curve all day (which is surprising on a 30yr bond auction day).  The belly/front-end of the curve saw decent selling, but the 30yr did not (again, very surprising for a bond auction day).

Going into the auction, the wi 30yr ("wi" = "when issued" - which is what we call a bond before it is auctioned) was trading 3.89%.  The 5yr and 7yr points on the curve were trading near the lows of the day (the 30yr bond was trading 97-17+ @ 3.89%....and the low price pre-auction had been we went in to the auction pretty close to the low).  The auction priced 97-10+ @ 3.90% (so, a 1 basis point tail = 1bp cheaper than where the bonds were trading in the secondary market going into the auction). 

Now, this is the exact same type of result that we saw at yesterdays 10yr auction (1bp tail) but the lead up to the auction was entirely different, and the price action post-auction is also completely different.  Yesterday, the market rallied right into the auction and went in right near the day's high. Today, the mkt sold off pre-auction, and we went in close to the lows (the 30yr bond was strong on the curve...but outright price was still lower on the day - especially if you look at the belly of the curve).  Yesterday, the auction tailed 1bp, and the mkt sold off like a banshee.  Today, the auction tailed 1bp, and the mkt hasn't really gone anywhere...the mkt is going sideways in-between the auction stop price and the pre-auction price.  This is VERY RARE for a 30yr auction.  The result is almost always a big surprise one way or the other.  I was saying before the auction that the entire mkt felt very weak, which indicated a tail was coming.  Since i went into the auction short and was bidding to cover that short and get flat, i was hoping for a much larger than 1bp tail.  The result of only a 1bp tail was a "meh" result (still made a trading profit, but i was hoping for more).  For a 30yr bond auction, i would consider a 1bp tail a practically "screws" result...and that explains why the mkt is just chopping sideways since the auction..this means the mkt was perfectly positioned, everybody is happy and nobody exited the auction with too many or too few bonds from the result.

If you are wondering "what next?"  Well, next week the US treasury is auctioning 2yr, 5yr and 7yr notes.  This is unusual (these auctions typically take place in the last week of the month) but the holiday calendar has pushed things up.  This may partially explain the weakness in the 2-7yr part of the yield curve.  Also of concern to the belly and front-end of the curve is the article recently published in the NY times talking about Fisher's views of forward guidance.  His comments on forward guidance were very "indecisive" regarding the front end of the curve, where the mkt has experienced and was expecting the more reliable "lower for longer" mantra.  This combined with the auctions next week are both reasons for the front end of the curve to sell-off...and so it has.

Until we get new information, or surprising price action, i'll be flat and waiting.

If you would like to see my thoughts on the UST market intraday as well as see my actual trades in real-time, then i would suggest joining my private twitter feed.  The signup link is on the top-right of my blog.

Wednesday, December 11, 2013

10yr Auction Post Mortem + 30yr Auction Thoughts

Today the US Treasury auctioned 21bln 10yr notes (re-opened the Nov-2023 issue). 

Going into today's 10yr auction, ever since the NFP number at 8:30am on last Friday, the US treasury market has been in short covering mode.  There was a markets survey that indicated the active trading participants in the treasury market were extremely short (by over 30% which is huge) a full week before the NFP data was released, and the short position continued to build as we approached NFP.  The NFP number was strong (+200k jobs) and so the mkt immediately repriced lower as you would expect.  However, the important piece of information was not the NFP, the important information was the mkt's aggregate position (very short going in), because in the end, it is positioning that drives trading activity.  So, what would you expect this large community of shorts to do after the market dropped in their favor because of the strong NFP data?  If you said "cover their short by buying the market," then you would be correct. 

Normally (in the past), this type of short covering event would take place in a single day.  However, because this net short position took multiple days to develop (since Dec-1), and was so widespread (not only was the short position large in size...but it was large in the number of participants that were involved), the following short covering rally has taken a full 4 days to work thru the market.  I can say with confidence that now, that large short position has mostly been covered.  This does not mean the market is long...this just means that the market no longer has an embedded short position that needs to buy to cover.  

From all our lessons on market behavior, we know that when the last short covers (is done buying) the market stops going up (no more buying) and falls back down to around where it all started.  I think we've just about seen that.

So, the question to ask is "now what?"

Tomorrow we have the 30yr bond auction, and next week the 2yr, 5yr and 7yr auctions.  So, the market will need to reset those shorts to absorb the upcoming supply.

I could say a bunch of other fluff to fill space, but that really is all there is to it.  The mkt must have a certain amount of short position embedded to make room to buy the supply (auctions), and so, i expect a pop in the market to be sold to facilitate that supply process.  If the market does not "pop," thereby not enabling the market to get short again, then i expect last minute setup selling, and perhaps another tail in the 30yr auction tomorrow.

That's about all the strategy I have for now.  Levels will be available on the private twitter stream.


Thursday, November 14, 2013

US Treasury 30yr Auction Post-Mortem

Today the treasury auctioned off 16bln 30yr bonds at 1pm (ET).  This occurred during a fairly volatile backdrop.  Janet Yellen was answering questions from the Senate for much of the "setup" period.  Her testimony was fairly QE - supportive, and so the bond market rallied during her entire testimony.  Then we had a 3.5bln 10yr POMO @ 11am (ET) 2 hours before the auction.  This was the pre-auction crescendo that many day traders are familiar with.

Bonds rallied right into the 20minute period after the 10yr POMO in a crescendo of volume....and then fell back down to the overnight VWAP after the 1pm 30yr auction tailed 1.5 basis points.

(pictured are 30yr UB futures vs inverse DX futures)

I suggested selling bonds at 11:20am this morning into the crescendo of volume, and covering after the auction.  As a trader, i couldn't really think of anything else to do.

Up until the 10yr POMO, the 10/30 curve was stable at 108 basis points.   This indicated that a concentrated short setup had not taken place.  However, after 11:20am, 30yr bonds started to underperform (both outright price and on the curve), indicating that the setup (selling bonds pre-auction) had begun.  I thought the timing of this setup selling very coincidental.

While the treasury market is still generally strong post-auction (the belly inparticular), the fact that the 30yr auction tailed indicates that the large short base pre-Yellen speech release has mostly covered and the market should be fairly stable in the current price range.

 (UST yield change on day)

Typically, the treasury market builds a concession pre-auction, and actual investors of US Treasury paper buy these auctions to get long.  Today that is a scary trade (getting long) because the market has repriced higher after Yellen's early-release speech last night.

As a day trader, i won't participate in that trade...but as a portfolio manager, i'm sure that many are.
 With Janet Yellen at the helm, its clear that the economy will need to clearly demonstrate deep economic strength before she will consider reducing QE...and that may be a long time away.

If you are interested in this type of bond market commentary intraday, in addition to following along with the trades that i am doing in the market, then i suggest trying out my paypal subscription twitter feed.


UST 30yr Pre-Aution Thoughts Before Yellen Confirmation Hearing

On any other 30yr auction day, i would be selling 30yr bonds right here (9am in NY) (30yr bond yield @ 3.79% and UB futures @ 140-21   both higher in price by 4 basis points on the day) in anticipation of the 16bln 30yr bonds (32bln 10yr equivalents) to be auctioned in 4 hours.

(pictures 30yr UB bond futures vs inverse DX)

However, today is not any other day.  Unemployment claims are slightly up...more than expected, labor productivity is up, and unit labor costs are down.  All of these point to no desire to increase hiring.  That is bad for the consumer (because the consumer is labor), and hence bullish for bonds.  These numbers ought to also be bearish for stocks (a weaker consumer does not increase sprnding)...but it seems the QE fever is still keeping S&P futures high before the open.  In a world where more QE = higher stock prices...Yellen's prepared remarks released yesterday made no mention of taper, and were highly supportive of QE continuation (though she did not explicitly state that).  The remarks were vague, but erred on the side of continuing current accommodative policy (so, QE-4-ever).

This causes a conundrum. Regardless of Yellen's testimony and Q&A session this morning, there will still be a 30yr bond auction at 1pm (ET).  Given the strength and low volume yesterday, and the current bullish tone of the bond market (4bps stronger from yesterdays closes) the bond market does not feel like there is a significant setup of short 30yr positions.  This must take place before the auction.  Primary dealers must each bid for their pro-rata share of the auction (so about 800mm each).  No dealer wants to come out of a 30yr bond auction long 800mm 30yr bonds...its just too much risk in a world where directional risk is shunned.

This is the backdrop in the minds of bond traders as we approach Yellen's testimony and Q&A session.  We will be reacting to her testimony with this in mind. be clear...if she does not indicate a desire to extend QE (either in fact, or by indicating a lower unemployment threshold) then there should be good selliing of 30yr bonds to setup for the 1pm 30yr bond auction.

Typically, bond traders want to come out of the 30yr bond auction long bonds...but typically that occurs from a very low price, as the market usually sells off going into the auction.  Today that is not the case (so far).  I expect today to have unusually high volatility in the bond market....but we will just have to wait and see.

I'll be active on twitter feel free to join in the conversation.


Wednesday, November 13, 2013

UST 10yr Auction Post Mortem

The UST market grinded higher today, right into the 1pm (ET) 10yr auction. The 10yr auction came at the EXACT high print of the day on the current 10yr note @ 2.75%.   This is uncommon for a low volume day (i was expecting a tail...instead the auction came on-the-screws, at the high of the day).

Typical trading volumes for a 10yr auction day are around 450bln 10yr equivs. Today we are at 240bln 10yr equivs (asof 1pm), and on target for a 360bln 10yr equiv on track for an 80% volume day.

The USD index (DX) was weak today, which typically creates strength for US Treasuries. This held true today, and probably explains a portion of the bid in the UST market going into the 10yr auction.

(pictured are 10yr futures vs inverse DX futures)

While there is no use crying over spilt milk (most traders go into the auctions short, and then bid to cover that short, hoping for a Dutch treat), lets start to think about what this means for tomorrow's 30yr bond auction.

We know there was a large-ish UST short position initiated after NFP on Friday.  I can only surmise that this aggregate short position (combined with general USD weakness) is responsible for the strength in todays 10yr auction.  With the treasury market still sticking at the highs of the day (in fact making a new high as i am writing this), it feels safe to assume that there is more short covering to be done.

This is the backdrop as we now begin our approach into tomorrow's 30yr bond auction.  30yr bonds have underperformed on the curve today, which tells us that a short 30yr setup has already begun (possibly outright..possibly on the curve).  We will have more clarity on that point tomorrow.

Trading volumes were very low going into the 10yr auction..and are still low 30 minutes after the auction.  It feels like a significant sized group of market participants are not participating in the US Treasury market.

More later on twitter

Tuesday, November 12, 2013

Surprise - US Policy Reduces Trading Volumes AND Liquididty In The US Treasury Market - BRAVO

The US Federal Reserve Bank has been easing quantitatively (QE) for 4 years now, since 2009.  Over this period, average daily trading volume in the US Treasury market has reduced from 500bln 10yr equivalents per day to 350bln 10yr equivalents.  350bln 10yr equivs may still seem like a big number...but this is a 30% decrease in trading volumes, and that is a reduction not only in volume, but liquidity.  Some readers out there might think"so what?" or "whats the big deal if the US Treasury market is less liquid than it used to be?"  The answer rests in the ultimate lenders of capital, and the structure of the Treasury market which is of great concern to participants of this market.  Investors (yes, a rarely used word these days) prefer to invest in assets that are liquid, especially when that asset is designated as a "risk free" asset.  Liquidity = ability to enter / exit at tight spreads without affecting the market price for the security.  The US treasury market used to be the deepest most liquid bond market in the world.  This characteristic of the UST market has significantly faded as QE has run its course, and the result is a reduction in actual "investors" of US government debt.  This is partly why the US Fed is still doing QE.  If the Fed doesn't buy US govt bonds...who will?  The value of the USD has been cheapened by QE, and that significantly increases the risk in holding UST debt.  Think about that for a moment..the US Fed's actions have increased the risk of holding UST paper.  UST paper is supposed to be the "risk free" asset against which everything else is judged.  If the "risk" of holding the "risk free asset" are investors to measure "risk."

 I will leave it to the reader to draw parallels to the situation as it is currently playing out in Japan.

The Fed engaged in QE for 4 specific goals.

1)  Push investors out the credit curve (from UST --> corp bonds --> Stocks)
2)  Reduce / keep down interest rates to fund US Govt spending
3)  Increase inflation (for example, prop up the housing market)
4)  Decrease unemployment

Of these 4 goals, #s 1-3 are credible.  #4 is not so clear.

#5 is not a "goal" but an unintended side effect.
5) Reduced secondary market net supply while increasing supply of the currency  = reduced trading volume = reduced liquidity

I suppose i could repeat the phrase, "when the only tool you have is a hammer...every problem looks like a nail"

Here is a direct example of #5

This week is the refunding for long term UST debt (10yr notes and 30yr bonds).

With the QE induced reduction in trading volume and liquidity, expect the remaining market trading participants to continue selling UST's ahead of the "make room" before bidding on bonds in the upcoming auctions (remember, primary dealers are required to bid for their pro-rata share of every about 5% each).   As the US Fed continues to print USD to buy UST, the world incrementally loses trust in the value of the USD. Think of the tipping point (currently taking place in Japan as well).

Of course, there has been talk and speculation of the Fed reducing / ending their QE program.  Unfortunately, there is no way for the US Fed to "exit" their QE program.  The only exit option is to wait for the debt to mature and swap IOU's with the US Treasury.

The market is a discounting function, in that it discounts future expected values in the current price of assets.  This means that ultimately, when the market realizes that the Fed cannot exit its QE position (i'm amazed this hasn't happened yet), the discounting function requires the price of UST debt to drop, yields to rise, and the currency to cheapen.  And here is where the Fed holding a sizable portion of all outstanding UST debt becomes both a problem, solution, and problem again.

1) Problem:  QE reduces value of the currency, and thus (reduces desire / increases risk) of holding long term US govt debt.
2) Solution: the central bank steps in and buys the long term debt, inflating financial assets
3) Financial asset inflation translates into consumer price inflation
4) Problem:  --> see problem #1

5) The modern world hasn't figured out #5 yet, however Japan is on the path to experience #5 before the US.

It is hard to imagine life in the US falling over due to financial failure, as happened in Greece and Cyprus.  Of course in the US it would be slightly different, as the US can print money and inflate away certain problems.  The scary part is when those who have been inflated out of being able to survive get hungry enough to riot...that is when chickens in the US will come home to roost.  This is a slowly building does not happen overnight.  And every slowly building phenomenon has a "tipping point."

Back to the markets....

As volume and liquidity decrease with the path of QE, we continue to get closer to the moment when the market actually discounts this reality.  This is the only reason US bond yields are as low as they are (the same could be said for European Govt bonds).  The market hasn't fully discounted this "non-exit exit."  Similar statements could be said about the situation in Spain, France and Italy.  Amazing our ability for cognitive dissonance, no?

While this all sounds oddly familiar to a ponzi scheme (the kind that goes along fine until one day it implodes)...the effect today is a reduction in both liquidity and trading volume which has created "volatility gaps" or "bifurcated volatility"  This is simply recognizing the path that we are currently on.  I don't expect the govt (US, Europe, China or Japan) to reverse course...its just important to recognize where we are on the path.

Here is the real purpose of this should i change my trading strategy to adapt to this new volatility regime?

Until recently, the average daily trading range for 10yr note futures (the most liquid UST security) was 20 ticks or about 8 bps (a tick here is 1/32nd of 1 USD of face).  Of course when we say "average" that implies some daily vol ranges are bigger than 20 ticks...and some are smaller.  Days with significant ECO data (NFP, FOMC, large duration auctions, Housing data,  CPI, ect..) expect larger than average trading ranges and volatility.  Days with less significant ECO data expect less volatility and smaller trading ranges.  This basic concept still holds true today...but the gap in average volatility between a big vol day and a small day has increased (much like the gap between the rich and the poor).   In today's market, a large vol day might see a 12-16bp range...and a "normal" small vol day might see only 3-5bp trading range.  5 years ago, these vol range were more like 5-8bps and 10-18 bps.  The result is that during the intermittent "slow periods" the market is extraordinarily slow..and during high vol events, the market reprices so fast that large entities do not have the ability to change their position before the market has significantly repriced.  This is what we call a reduction in liquidity.  As a small individual trader, you may think this does not have a significant impact on your day-to-day life.  But as an investor in the institution (do you have a bank account?  do you have a pension fund?...then you do have a stake here) this affects us all as the cost of hedging interest rate risk has significantly increased.

So, as a day trader, how do we respond to this change in the structure of market volatility?  It means that the average mean reversion trades have much smaller ranges.  If you "need" to make X dollars per day trading...and intraday vol is reduced, then you must therefore trade larger size, with more leverage to make up for the reduction in average volatility.  This poses a problem to our internal risk manager.  Increased size / leverage on your account means tighter stops in terms of price ranges (for example, risking 5k to make 15k).  With larger size you will lose 5k faster if the market moves against you.  So, this increases the probability that you will get stopped out, and thus decreases the expected value of your mean reversion trading strategy.  An option is to not increase your trading size / leverage.  However, with the smaller vol ranges, this implies that you will not be able to hit your revenue targets, and this has caused banks and hedge funds to look elsewhere for their trading / liquidity providing business.  This is why trading volatility has participants have simply gone elsewhere...which reduces not only trading volume but liquidity.

These conditions are what drive traders (liquidity providers) out of an illiquid market, and into a different, more liquid market.  Illiquid Markets tend to be "sticky" when trading volumes are small..and "gap" when trading volumes increase.

So, what is my advice?  You could either take your stake, pull out and go find another more liquid venue to trade (FX perhaps?).  Trust would not be the first.  For the remaining traders...there is still opportunity..but that opportunity comes with increased risk.  This is the hallmark of an emerging market (yes, we are still talking about the US Treasury market).   This all sounds reminiscent of stories about traders who blew up when volatility "gapped."  LTCM is the most famous, but there are numerous others.

To be clear, i'm not advocating traders leave the UST market..i'm simply pointing out that market structure has changed...and in order to survive, we as traders (intraday liquidity providers) must either change with it....or be pushed into insolvency.

So how do we change our trading strategy with this decreased average volatility?  We need to be more aggressive.  This applies both during the slow mean reversion trading days, as well as the trending trading days.  Gone are the days where you can sell a good pop...or buy a good dip.  Now, you need to figure out your intended direction, and initiate trade closer to the middle.  This of course increases the risk that you will get stopped out if you are making such decisions on a random basis.  You have to "know" what will happen next.  Does this describe how you "feel" about the US Treasury market?

Yup...still talking about the US Treasury market here.  Surprised??

Friday, July 19, 2013

Why Do Treasury Traders Complain About Low Trading Volume??

On the one hand, for just about everybody trading in the UST market, there is always enough liquidity to put on or take off a position, in full, at any given moment.  How many traders trade more than 1000-2000 10yr contracts?  You can always buy or sell 1000 10yr contracts without moving the market.   While this is a problem for the primary dealers (who often bid / offer 1bln 10yr notes for their customers...the equiv of 10,000 10yr contracts), this is not a problem for the average day trader.

However, the price action patterns that occur when 50mm/bp (60 bln 10yr note equivs) trade in a 15minute time bar...vs when 5mm/bp trades in a 15minute bar...well, they are just different.  I know that statement is a little vague, but its difficult to put into words what we traders have learned via pattern recognition.   Everybody sees this activity in the screens, and the existence of this activity means more traders (large traders) are participating in the market.   Even though the UST market is the "deepest and most liquid bond market in the world"....there are still quantities that scare even the primary dealers.  The benefit of having large volume trade in the screens is the mechanism of price discovery, and volatility.  Scaring the dealers (the liquidity providers) enables things like short covering rallies...long liquidations, supply distributions, and the like.  The more volatility...the more price discovery...the easier for day traders to read what the larger market participants are doing...and thus...the easier to follow along.

To a certain extent, this is just a gripe....but today, for example, 10yr futures were stuck in a 4 tick range for 7 hours (10am --> 5pm)!!!  This is just not normal.   Also, the price discovery process (price action) normally has a volume measured moves based on a certain quantity of volume.  With the lack of significant volume trading in the market...price doesn't move enough...doesn't create enough volatility to get an accurate "read" on the direction of interest rates.  Volume tends to create volatility...which tends to bring in additional market participants.  Its that age old saying...volume begets volume.

This week, daily trading volumes were 50-60% of average for the past 2 months, and intraday volatility was reduced by a similar margin.  I'm hoping that the hot July in NYC is not a coincidence.  I'm hoping that many large traders are simply on vacation and will return at the end of the summer.  If not...then my trading strategy will need to change.

Of course, my complaining won't change anything.  Until trading volumes return, the best volatility will occur during London trading hours into the NY morning...and the NY afternoon will be the dead zone.

Monday, July 15, 2013

US Long End Auctions (10yr and 30yr) Post Mortem

Wednesday and Thursday of last week were the US 10yr and 30yr auctions.  These auctions (combined with the price action in the secondary market leading up to the auctions) are the best times to gauge demand for UST paper.

1st the 10yr:
Heading into the 1pm auction, the market for UST paper was weak.  The most recent comments out of the Fed indicated the FOMC was planning on tapering their bond purchases starting as soon as September.  The mkt grinded sideways to lower all morning.  The mkt went into the auction at the lows of the day (asof 1pm)....and the auction came at the market (0.1bp small of a tail lets call this on-the-screws).  The FOMC minutes (came out 1hour after the 10yr auction) indicated that some Fed Members wanted to taper QE back in June.  This surprised the mkt and the 10yr mkt traded lower to below the auction price by a few ticks on decent volume.

Then Bernanke spoke to an economic club, and around 4:45pm EST made comments that the recent labor market statistics, including the unemployment rate, under-represented the problems in the employment situation in the US.  Bernanke said that because of this, the Fed would remain accommodative for an extended period of time.  He didn't specifically clarify if this comment on "accommodation" was referring to the Fed Funds rate, or to QE.  The market knee-jerk reaction interpreted this comment as "Taper-OFF"(recall this was just 3 hours after the hawkish FOMC minutes)....and 10yr futures rallied  1 1/4 handles in a very illiquid session (from 125-05 to 126-15+).  This felt like another "game changer"  Many market strategists were unhappy that BB would make such comments when the mkt was for all intents..closed.

2nd the 30yr:
The price action for the 30yr bond auction the following day was interesting.  The 30y mkt almost retraced its entire BB spike from the prior day, for the setup going into the auction..the mkt was illiquid and low volume all day.  It seemed like the auction setup was the only trade occurring that day.  Again, going into the auction the mkt was trading at the lows of the day asof 1pm (recall, this is 18hrs after BB's comments the prior day).  This time, the auction came stronger and stopped short (came thru the 1pm price) by 1bp (about 5+ ticks on the 30yr).  The 30yr bond proceeded to rally 16 ticks from the auction into the close.  Many traders described this auction sarcastically as "couldn't see that coming."

In the 2 days since the 30yr auction, many strategists and Fed watchers have commented that the "Taper-OFF" reaction to BB's comments may have been "too artificial".  They point out that BB's comments regarding accommodation could just as easily be referring to the Fed Funds rate, and have no bearing on QE. (since traditionally, the Fed Funds rate was THE mechanism for accommodation).  BB must know this (he's not that clueless) many rates strategists describe his comments as an effort to talk the mkt "up" without needing to do very much.  The longevity of such verbal efforts seems to be decreasing.

The Fed and Fed reporters have stressed that they think they can "Taper" QE and have no impact on market interest rates.  The market has made an effort to say "incorrect."  While the Fed has explicitly stated that a reduction in QE could be followed by an increase in QE if they detect negative influences in the economy...the market just doesn't believe.  While its true the mkt is forward looking....they just aren't THAT forward looking.  The market sees any reduction in QE as a direct path to NO QE.

Nobody knows for sure if QE is actually helping main-street (arguments go both is usually the case in economics)...but we can say with confidence that QE is helping other asset classes such as the stock market and related interest rate markets (hello mortgages).

As i write this, the UST market is selling off and looks like it may "fill the gap" to BB's comments on Wednesday evening.  Regardless...the ultimate conclusion of the mkt thus far is one of confusion.  Will the fed Taper...or won't they.  Both the FOMC minutes, and the Fed Speak afterwards from various fed speakers have been contradictory.  Its clear there is a disagreement inside the Fed itself regarding what the best course of action is.

Over the past week, volumes in the US treasury market have been hovering below 70% of average.  There have not been large initiating trades one way or there other.  Perhaps this is due to the summer season surrounding July 4th (its gotten hot in NY...and many participants have gone on vacation).

I myself eagerly await the return of the large i can return to my usual tactic of following them (my most profitable trading strategy).  Until then, its probably gong to be a dicey market to trade.

good luck

-govt trader

Tuesday, July 9, 2013

Converting UST Market Volume to Interest Rate Risk

A question from a subscriber about Market Volume, and my response:
Govt - can you explain this: "12mm/bp traded over last 30 minutes". I know you are referring to volume, but beyond that, I can't figure out what it means! Also, it would be helpful (at least in the early stages until we catch on) to get some explanation for the meaning you are taking from the volume figures that you cite. They must be important to you, or you wouldn't be tweeting them. Is it high volume or low volume - and how is that volume figure supporting or invalidating your working hypothesis?
--my response-- (this is a little long..but you'll learn something)

 US Treasuries all share certain characteristics 
-they all pay their coupons semi annually
-they all accrue interest on the same Actual/Actual DayCount Schedule
-they all have their own maturity date
-the formula to calculate price --> yield...and yield --> price is the same for all UST securities (the only variable is coupon and maturity date)

So, we can do some simple bond math on them...and apply it the same way.

Now, all US treasuries have a market price...and each market price is equivalent to a specific yield. For example, today (July 9) the current 10yr notes bid price of 92-07 = a yield of 2.653%

There is a formula to calculate a yield from a bond, given its price.  There is a similar formula to calculate a bond price, given its yield (these are inter-changeable).

We can change the yield on any UST security by 1 basis point, and we can then calculate the new price (so back to our 10yr example 92-07 = If we change the yield to 2.643% (1bp lower)...we can then calculate the equivalent price...which would be approximately 92-095 (2 5/8 ticks higher in price for 1bp lower in yield). This is the sensitivity of the 10yr note price (2 5/8 ticks) for a 1 basis point change in yield of the 10yr note (from 2.653% to 2.643%).

If we do the same exercise for the other securities on the curve, we will find different price sensitivities to a 1 basis point change in yield:

2yr    5/8 of a tick
5yr     1+ ticks
10yr   2 5/8 ticks
30yr   5 1/4 ticks

--Update --> including treasury futures

ZF (FV)    1 5/8 ticks
ZN (TY)   2 1/2 ticks
ZB (US)   4 3/4 ticks
UB (UL)  7 1/2 ticks

These are the changes in price for these securities for a 1 basis point change in each of their respective yields. This value is referred to as PV01...or...the "price value of 1 basis point" change in yield for the security.

Why do we care about this?
Because the 1st assumption in bond trading is that all securities move in lock step on a YIELD basis. Meaning..when the market rallies in yield...and all securities rally or selloff in the same amount of yield. (of course we know this is not true...and we deal with that later...but it is a 1st level assumption which allows us to speak about bonds with different maturities in a apples to apples comparison)

So, imagine you are long 1mm 10yr notes...and you decide you do not want any outright exposure or market risk, to a change in the level of interest rates.

You have a couple choices:

1) you could sell your 1mm 10yr notes making you flat
2) you could sell another instrument (perhaps a 30yr bond), as a hedge against your 10yr notes

In option do you decide how many 30yr bonds to sell, to hedge your position in 1mm 10yr notes?

The answer comes from their PV01. You will notice that the 30yr PV01 (5 1/4 ticks) is DOUBLE the PV01 of the 10yr note (2 5/8 ticks). This means that the 30yr bond price will move DOUBLE the amount that the 10yr note price moves assuming parallel yield changes...(for ex...all UST yields increase by 4 basis points).

So...if the 10yr note sells off by 4 bps (remember, price down = yield up)...
the price change will be 4 * 2 5/8 = 10+ (10 and 1/2) ticks.

If the 30yr bond sells of by 4 basis points...its price will change by 4 * 5 1/4 =21 ticks.

In order for the P&L of the hedged position to be = 0 in this scenario (parallel yield change)...we would need to sell 0.5mm 30yr bonds to hedge our long 1mm 10yr notes position.

Or in other words..the hedge ratio = 10yr PV01 / 30yr PV01....or (2 5/8) / (5 1/4) = 0.5

We now know that 1mm 10yr notes are equivalent in a parallel yield move to 0.5mm 30yr bonds. The P&L of the 2 positions will be equal and offsetting.

I hope you are still with me...cuz we are just about done...

The actual dollar value of 1mm 10yr notes = $312.5/tick * 10yr PV01 (2 5/8 ticks) = $820.
This is referred to as DV01.  The only difference between DV01 and PV01 is multiplication

DV01  = PV01 (ticks) * $312.5 / tick / 1mm

This mean that when the 10yr note moves 1bp...a position of 1mm will move (in P&L) $820. A position of 2mm would move (in P&L) 2 * $820 = $1640

If we do the same exercise for the 30yr bond...we find that 1mm 30yr bonds PV01 of 5 1/4 ticks * $312.5/tick = $1640

So, 1mm 30yr bonds are equivalent to 2mm 10yr notes (in P&L exposure assuming a parallel move in yields).  

Back to quoting Market Volume 

When we count the volume traded in the mkt...we first count each security on its own (10mm 10yr notes trade....then 7mm 30yr bonds trade, etc...).

However...if we want to add the volume together (in this example 10 + 7 = 17)...we can't...because it wouldn't be an apples to apples comparison in terms of P&L exposure. While saying that 17mm US Treasuries just traded is technically does not give us a meaningful description of how much INTEREST RATE RISK just traded.

In order to get an apples to apples comparison..we need to convert each securities VOLUME into DV01 (dollar value of a 1bp move in yields). We do this by multiplying each securities VOLUME * PV01 = DV01

When i quote 17mm/bp traded in the last 30min..i am saying that the total DV01 traded = (the sum*product of the Volume * PV01 for all US Treasuries that have traded in the market in the specified time interval).

If i wanted, i could then convert that DV01 into an equivalent amount of 10yr notes.
17mm/bp = $17,000,000 (total DV01 traded) / $840 (DV01 of 1mm 10yr notes) = 20,238 million = 20.238 billion 10yr notes.

These are equivalent statements. 

By aggregating the DV01 traded of all the securities together...i'm not telling you what the composition of the market volume was. Perhaps all the volume came from trading 5yr notes...perhaps it was all 10yr futures (ZN)?? In that case, would it make sense to quote market volume in terms of 10yr notes? (while equivalent is technically can be misleading)

This is why i tend to quote DV01 traded (17mm/bp)...rather than 10yr note equivalents traded (20bln 10yr equivalents) (even though they are interchangeable)

In other words...when we are counting total market volume, we tend to not care what the structure or composition of the volume is (how much much much 2yr...etc..)...we just want 1 number..which makes it easy to grasp quickly what the "status"of the market is.

Now, of course its also valuable to know where the volume is coming from (how much DV01 from each instrument) when the curve steepens or flattens...or in other words...what is the composition of the volume trading in the market (how much much much 2yr...etc..) compared to the change in yields of the various instruments.

So in 1 sense...we don't care about composition..and in another sense...we do care.

When we just want to know how much volume has traded...we don't care so much...but when we want to understand the movement in the curve (when it steepens or flattens)...then we do care about the composition of the market volume....but that is a different type of question.

That is the end of today's lesson - are there any questions?

Monday, July 1, 2013

My response to a valid reader question - "why your premium service?"

RE: Marks comment

why sell the 'tips'? Why not just make a lot of money and retire? I am genuinely interested in your service, but as Livermore said "If you need someone to tell you when to buy, who will tell you when to sell?"

i completely understand this comment...and until i started blogging / tweeting my trade ideas over the last year...i had the exact same opinion of trading "advice" from an anonymous guy on the internet.  Here is my response. 

I don't intend to just give my buy/sell levels (yes, i'll give you those).  i don't think these alone will really help most traders tho...because of the inherent fear of trading which you allude to) premium service is more than 70% additional "education" info where i talk in more depth why i make certain decisions and how my thinking process works.  

My subscribers will attain their best trading results, as do i, when  they understand what type of pattern the market is experiencing.  Sometimes the pattern my model identifies is very short term (minutes to hours)...and sometimes slightly longer (hours to days).  Once  my model (and hence, i) understand the type of pattern that the market is going thru, my model creates buy and sell levels that make sense in light of the pattern.  If the market generates price action which invalidates the pattern, then the model gets stopped out and continues searching for the next pattern.

As time and days go on, subscribers to this service will learn to identify and classify these patterns.  Sometimes, an invalidation of a pattern can become a pattern in and of itself.

Over time, this will be similar to the experience that my junior traders used to have (for years, i was the guy on the desk that had the kid from MIT/Duke/Princeton sit next to me for 6-9 months as i taught / he learned the internal dynamics of the treasury market).  I have a technology background, so teaching was not hard for me, because i started out as an "outsider".

While i'm confident that if you were to follow all my trades and trade alongside me, you would have a positive net P&L, i'm even more confident that after spending 6 months to a year on my service, you will be able to anticipate many of my trades and ideas before i even post them...or when i post them you will think..."that's exactly what i was thinking"..and the reasons behind my thought process can help explain your own thought process, and give you more confidence, which will help you enter and exit the mkt (selling a pop...or buying a dip) instead of being paralyzed with fear and greed (the demon of most traders).  Its scary sometimes to sell a pop to initiate a short position (if the market is popping...then maybe it will keep going up...yikes!!!)  However, selling the right pops and buying the right dips are the ideal methods to generate P&L in the interest rates markets.  Generally, interest rates tend to mean revert so a fair value level.  The problem is that this "fair value level" changes from day to day...and the change can be a lot.

If you spend enough "screen time" staring at the treasury market along with me, i suspect you will start to notice patterns.  This normally takes at minimum, 1-2 years (don't take my word for it...go ask other traders).  It took me about 3 years before i felt like the treasury market was "speaking to me"...i was slow in this regard.   Part of recognizing patterns is having a frame of reference to start with.  Everybody has access to intraday price that is the common form of reference...but without a basic guide on how to read a price is difficult to discern the patterns at play.  The model that i've developed gives a frame of reference from which to view these price charts.

This "feel" that i refer to is not always there...but after enough time, i am now able to feel when the mkt is speaking to me...and when it is not (thanks to this model).  Now, when the mkt speaks to me..i trade..and when it doesn't i try to not trade.  You might say that the mkt has an ebb and flow like the ocean...and after enough time...when the waves get sufficiently really can feel them in the screens (the model discerns a pattern and projects a continuation of the pattern creating buy and sell signals).  One of the mistakes traders often make when they first experience this is to think that the "feeling" of a particular read will continue.  For example, after enough time...i've learned that most "ebb and flow feelings" are temporary...and are best used to get in and out of the mkt in short time-frames (usually less than an hour..and usually for 4 to 8 ZN ticks).  When i first experienced this..i was great at picking entry levels and my position would quickly make 3-5 ticks...but then the feeling would fade, and instead of exiting for a small profit when the "feeling" faded...i would wait for a large profit ("i think" would turn into "i hope") and instead i would watch the mkt take it all away.

This type of mkt feeling is difficult to ascertain if you haven't sat on the trading desk of a primary dealer, because of all the information that passes thru those desks (some info is trades..some is the opinion of very large traders such as Buffet, Soros, PIMCO, SAFE and the like talking with the head of the desk).  That flow information (while useful for scalping) is most valuable as a tool to learn what effect certain volume trades have on the mkt (you can't imagine the power and control you have over the mkt when you get to do these large flows and nobody else knows).  After seeing enough of can get a feel for how certain chart patterns combine with certain volume trading patterns (i've embedded these patterns into the model).

I would have never picked up this minutiae if i wasn't part of a primary dealer desk...its not fair..but that's just how it is.  Maybe there are trading prodigies out there who can learn these patterns without this experience..but i wouldn't count myself among them.

The "bonus" is that after having seen enough of these flows, how they impact the mkt and how the mkt reacts to the flows hitting the screens, i can now "see" the flows in the screens even tho i'm NOT at a primary dealer anymore...and i have a general feel for which customers do what...both types of trades...typical size..typical placement...etc.  I've taken this experience and built a trading model around it. "conclusion" service, while useful in itself for the trading more useful as an educational service...and that's how i'm billing it...a premium education service.  If you were trading equities...i'd suggest one of the equity Virtual Trading Floors...where experienced intraday equity traders talk about patterns they see in the mkt in a chat-room.  However, my experience is in US Treasuries.

If you want to trade US Treasuries, and you have the opportunity to get a spot on one of the primary dealer desks...i strongly suggest you take it.  There is no substitute.  My service is an option for those who don't have that opportunity.  I haven’t found another twitter service / chat-room or other opportunity to follow/ talk with a former primary-dealer US Treasury trader with my experience who has made themselves available to the internet..   If any of my readers are aware of one…I’d happily reach out and get in touch with them (because I enjoy the camaraderie). 

Of course i already speak with my former colleagues…but you can never have enough info when you are dealing with a market that has so few large participants compared to the size and depth of the mkt.

Who do you talk to when you are trying to understand the US treasury market?…could you trade better if you widened your community??

Regarding questions about this new service and my own trading...yes...every trade i post on the private feed is a trade that i am making myself.  I cannot tell you what to do....but i can tell you what i'm doing.  I can tell you where / when i buy / sell..and i can tell you why...and that is exactly what i do in the private twitter feed.

Thursday, June 27, 2013

A Primer For Interpreting Random Market Profiles And Reactions To Economic Data

This a fairly broad topic, and any "rules" would be vague at best, so i'll use recent trading activity as an example.

First - the background:  The UST market has just exited a supply-imbalance.  "What is a supply imbalance" you ask?   A supply-imbalance is simply a state of the market where the markets general mean reverting force has become overwhelmed by a large broad based position, that was not wanted or intended by one side.  Imagine being given a long position in 50bln 10yr notes..and thinking "i don't want this."  You didn't go out seeking this position...but you are a market maker and 50 guys all said bid 1000mm (thats 1bln) 10yr notes...and violla..there you are (perhaps they hit you elctronically and you auto quoted...perhaps you just weren't paying attention to the accumulation in your book...perhapos "you" are the aggregation of all 20 primary dealers....the how is unimportant...the position is important).  You now have a position..and you want out.  You are afraid to sell into the market, because your initial small sale will most likely push the mkt against your remaining position.  So what do you do?  You sell some and you offer..that's what you do.  You offer and if the mkt ticks offer lower.  You keep doing this until your position is gone.  Unfortunately...during a are not alone...all the other market makers are in the exact same position...which is why the mkt seems to just melt when there is a supply-imbalance. you keep selling away your position (at this point the mkt has moved quite a bit against your position and your P&L is down millions) the original large seller who gave you the position will re-enter the market and say "i'll buy it all."  Of course they do this as sneaky at possible...they become the bid in the market, and perhaps they buy from the dealers thru proxies thus hiding their identity.  At this point, the original liquidity providers are just glad to exit their position without losing any more money.  At this point, lots of guys are worried about getting fired..going bankrupt..all sorts of fear is rampant for those on the wrong side.  The basic human psychology of FEAR is responsible for this behavior.  In this case...the FEAR of losing it all.  This fear is exactly what allows the original large seller to cover his position.  Now imagine this game repeated over and over and over again.  Clearly, being the large trader who can initiate this process is like a license to print money.  If you know the depth of liquidity of a market...then you can trade large enough to overcome that liquidity (one might even go so far as to say you are able to manipulate that market).  This is the trader that i follow at GovtTrader - he is our bread and butter.

Back to our original the supply-imbalance was created (big concentrated seller)...the market distributed (mkt sells off in price - a lot)...and then the supply-imbalance was alleviated (the big seller covers).  What happens next?  Well, the mkt has moved due to the trading activity we just discussed (in this case...4 points down..followed by almost 2 points up off the net/net down 2ponts (64 ticks) from where the original trade began)...and the mkt may or may not fully return to where the initial large traded started the whole thing in the first place.  Howerver...somewhere in the middle is where we expect the mkt to find stabilization.

That's where the UST market is the stabilization process post supply-imbalance alleviation.  The stabilization process is much harder to predict with accuracy than the supply imbalance induced supply distribution...because....well...the market's net position has returned to "balanced."  Balanced markets tend to behave randomly.  In the absence of anything else would expect the mkt to randomly drift back to the point from where our story started (129-00).  Balanced markets that have not been distorted due to supply imbalances tend to have a nice mean reverting shape.  But of course...we never have an "absence"...there is always something going on in the world..or somebody important talking about what they think might happen in the future...or some new economic data.  So, we start the day (like today) random with a potential skew up....the mkt shows us its initial balance (today 126-12)...or point of control...or the "mode" as we call it.  And the mode tends to control the market...until something else happens...and something else always happens.  That is why trading for mean reversion to the mode is something to trade for in the morning.  By the afternoon...there is new information...and the market will absorb all that new info (including trading activity) and gravitate to a new mode.  The new mode (this is the statistical term) might not be apparent until the afternoon or the following day.  This is yet another reason why we prefer to trade in the morning.

So, again back to our original question - how to trade a random market, and lets add "in the morning."  Since mkts move via trading activity...we expect the mkt to move away from the mode.  So long as the trading activity is not concentrated and 1-directional...we can expect that activity to gyrate the mkt away from and then back to the mode.  Sometimes we only get 1 chance to capture this...sometimes we get 3-4 (today we had 2-3...the 10am data...and the chop between 10:30am --> 12 noon).  To be time wears on...the probability of playing for a return to the mode diminishes...which is why the first trade in this model (in the morning) is usually the best trade.

Lets zoom-in on todays price action....

The market tends to react to economic data in a schizophrenic manner.  For example...the 10am PendingHomeSales data was strong (good for the economy...bad for bonds)...and yet..the mkt traded higher.  Dudley comments hit the wires talking about QE..but those comments were also bad for bonds.  When we step back and think about the PendingHomeSales..we realize that those data points came from before this recent rates in actuality not really helpful.  However, the mkts initial reaction to this data (via an algo)...take bonds (ZN) higher by 6 ticks (from 126-19 --> 126-25) which seems to hit a few stops (pre-10am we calculated 126-22 as the top of the bell curve on twitter)....followed by a slam back to the mode @ 126-12 (also described on twitter).  The market gyrated around the 126-12 mode (+/- 3 ticks) for the next 2 hours.   According to our "rules"...that's was time to stop trading.

The 1pm 7yr auction gave us a new piece of information...there was strong demand for paper.  Perhaps the bias for the mkt to return to the pre-supply imbalance price is stronger than we thought...that is certainly a possibility.  Then again...if the Fed actually does reduce QE (and communicate this)....should we expect a massive selloff?  Might that change the demand picture?  Is the current demand picture just a "front-run" of tomorrow's month-end buying?

Too many questions without clear answers.  So, i'll wait for tomorrow morning to show me if there is a clear mode that i can trade around.  Without a supply-imbalance to guide us...any decent sized flow can dominate the market.  This is the type of market where traders become economists...the mkt is slow, allowing us time to think.  Slow does not necessarily = easy.

So, we think the market is random...we know there is some bias to return to the price from whence we came, but we don't know how strong that bias is...and we have a scattering of economic and auction data (and FedSpeak) to help us try and understand what the market wants to do next.

So what do we know....
-We know the Fed doesn't like having such a large balance sheet.
-We also know that they like high un(and under)-employment even less. 
-We know that QE doesn't directly create jobs (the transmision mechanism is indirect at best...low-cost govt debt allows congress to spend more and inflated asset prices create a wealth effect which stimulates spending...and that creates some jobs...but the Fed would be much more effective if they just hired 8mm people for 50k/year). Cost 400bln / year.  This would be much more stimulative...and also much more inflationary...and the Fed can't do this.
-We know that banks aren't lending more money just because the Fed is doing QE (and bank-lending has been the source of most growth in the past)

-We don't know if the economy is growing fast enough to engineer a recovery.  My best guess is that the real economy is stagnant (unemployment claims and job growth seem to be net/net a wash).  Arguments can be made to slightly either side of that point...but nobody can say with a straight face that the economy is heating up such that the Fed needs to put on the breaks.

So...from the economist standpoint...there is no equivalent to a supply-imbalance that can predict what tomorrow will bring to the markets.  So was my economics degree a waste of time and money?  I now know that i don't know whats going to happen least i'm not ignorant of my ignorance...

We know tomorrow is month / there will be some month-end buying...but we don't know if the peak will be in the morning...or in the afternoon (the stats are split 50/50 on this).  After month-end buying is done...what else do we have?  3 Fed speakers tomorrow should create some volatility and give us a little more info.  In 2 weeks we have the next round of long-end (10yr and 30yr) supply.  We will surely have more FedSpeak (and jobs data) before we know there is volatility in our future.

In other words...we don't know very much.

Sure..if PIMCO decided to go surprise buy 200bln 10yr notes tomorrow...that would move the mkt and be a high probability trade to ride along with....but they are not going to do that's out the window (and if they are...they aren't telling).  Either waiting for a supply-imbalance that we can read (2-3 times per month)...or waiting for a morning mode-reversion trade, is the safest (statistically) trade to make...and so that's what i'll do..because i'm not a gambler...i'm a trader....i can afford to sit on my hands and do nothing when i don't have a clear advantage. 

You never know when the clear advantage will show up...and that's why we sit and stare at the market all when the opportunity presents itself...we will be prepared to strike.

There are probably a bunch of people out there who think traders like me are wasting our lives (essentially playing crowd-sourced video games revolving around money for a living)...and to an extent...they are absolutely correct....but no other job pays as either give me a better alternative...or let me make my money trading.

Tuesday, June 25, 2013

Creating a premium subscription service

So its been about a year that i've been experimenting with blogging / tweeting my trades / market thoughts.  As a former flow / prop trader for one of the larger investment banks, i used to just talk with other guys on the desk about our trade ideas to come up with what we thought was "market consensus".  Now that i've gone out on my own, its been a process of finding the right balance of reading social media "news" and talking with my former dealer buddies to recreate this experience.  As any trader can attest, the market can be a humbling beast.

I've found twitter to be a really good resource for market news, and also a convenient platform for sending out trade fits nicely with the short attention span of a trader like me.  Sometimes there are trading ideas that require more than 140 characters...which would make for better blog entries or entire articles...but my attention span usually keeps me from creating these.

I've also found that very few people understand my supply-imbalance model....and the supply distributions that result seem to catch a lot of people off-guard.

Over this time i've received many requests for more in-depth articles, as well as more detailed trading plans and more commentary on why i post certain trades on twitter...why i entered...why i exited when i did..etc...expecially when i identify a supply-imbalance  Since this blog, and twitter, were originally just a place for me to vent / note my trading ideas to keep track of my own trading, i never considered this platform would receive as much attention as it ha.

At the request of my readers, i'm going to try something new.  I'll create more detailed and in-depth write-ups of my higher confidence trade ideas (still in real-time) along with tweeting my actual trades and thoughts as the market develops, and send them out to subscribers of a newsletter type of service.  I'll still post on twitter...and sometimes on this blog...but i'll save the best (and real-time content) of my ideas for subscribers of this new subscription product.  I'm not sure how much to charge...its been suggested 500/month.  I'm sure professional traders and institutional traders wouldn't blink at that price (i used to pay a strategist 10k/month just to talk to me...but that was the investment banks its a little different).  I'm assuming that most retail account type traders have 25k in their futures trading account.  With an account this size, trading in clips of 5 ZN contracts (6k of margin) seems fairly reasonable to me.

For my introductory period, i'm only charging $250 / month for this subscription.
Where 5 ZN contracts = $156/tick utilizing 6k of margin....i'm fairly confident that a single day of successful trading will pay for a months subscription service.  Larger traders just get to ride the coat-tails of the smaller guys...its something i can live with.

So, if you like the in-depth type of articles that i used to post on this blog...and if you like following my trades on twitter, then subscribe to my new service.  It will be in both email a newsletter for ideas that are too large to post on twitter,  in addition to a private twitter feed for those real-time messages that just can't wait...such as trade entries and exits.  The frequency of the newsletter will depend on the market.  When i see supply-imbalances in the market, this newsletter service will be the only place i'll post that info.   That alone should be worth at least 2-4k/month to a retail account trading futures with 25k in your account.   I'll also create a special twitter feed that only members of the newsletter will have access you can get my full trading ideas as they develop in real-time. summary...this is what you'll get for 250/month (using paypal of course).
1)  A newsletter with detailed descriptions of the market profile...and how i read them.
2)  Access to my private twitter feed (this will be new) detailing my trades in real-time.
3)  The only place where my supply-imbalance analysis will be posted (this is the liquid gold).
4)  RV (relative value) analysis when appropriate, indicating the best instrument on the curve to trade
 to achieve maximum P&L potential.

Since i'm a trader and not a journalist, please forgive my grammar.

The button to join the subscription service will also be posted on the top of this blog.

Welcome to the new frontier....

Preferred E-mail Address
Your Twitter Handle

PS.  A few details
1)  You must provide an email address so I can send you the supply-imbalance emails.
2)  You must provide your twitter handle so i can authorize you to see my private twitter feed.
3)  Subscriptions require a Paypal account

Thursday, April 4, 2013

US Treasuries vs Stocks - One Of These Things Does Not Look Like The Other...

    Today saw a massive short covering trade occur in the US Treasury market.  A broad base of traders got short treasuries over the past few days (long end auction setup trades...and the usual group who just MUST fade every move).  Yesterdays weak ADP and ISM data brought in a large buyer of bonds (and a medium size seller of stocks).  Today the stocks market went sideways while the Treasury market was rocked...the herd of Treasury shorts was caught and fear overtook all rational thought.  There was a very high volume short covering event in the morning that lasted for about an hour and saw 100mm/basis point trade in a straight line "up"  (this is 4x normal volume for that time period).  While all this craziness was taking place in the Treasury market...the stock market was "unch."  Its as though stock market participants were completely unaware of what was happening in the Treasury market. 

    3 weeks ago (March 14th), S&P futures opened 1554 while 10yr Treasuty futures opened @ 130-10.  Today, S&P futures closed @ 1555 "unch from 3 weeks ago" while 10yr treasury futures closed @ 132-26  (thats 2 1/2 POINTS on a 7yr piece of paper).  

 3 weeks ago the relationship between stocks and bonds was priced at fair value.  Today, the stock market hasn't moved and the Treasury market has been ROCKED.  On a relative value basis, the Treasury market is now 20 basis points rich compared to the stock market.  To put that in S&P terms...the S&P is currently trading 1555....if the S&P were to move to accommodate the move in the Treasury market...the S&P would need to trade 1450...that's 100 POINTS lower (or 6.4%).  This is the most rich these markets have been relative to each other in years.  The current correlation regime has lasted 9 months  (treasuries and stocks have been dancing with each other in a stable fashion for the past 9 months).  Even adjusting for regime change, this move today is the richest these markets have been even during this current 9 month regime.

    So, either the regime between bonds and stocks has just changed...or the market has just given traders with cash on the sidelines a gift.  History has taught us that regime changes don't happen very often...and the smart move for a trader has been to fade these attempts to "break the regime."  Its true that someday the regime will shift, and we will enter a new regime, and fading a move like this will lose money.  Do you think that just happened?  Do you really think we just entered a new regime?  Its true that Japan just embarked on a new round of QE...and it is a 2.5 times the size of current US QE, and North Korea is threatening war.   Should that break the regime of the relationship between US stocks and US bonds?  Someday, something will do just that.  The question for traders you think the regime just shifted.

    Personally, I'm not convinced, and so i faded this move at the close by selling ES and ZN  (S&P futures and 10yr Treasury futures) at a ratio of 4 ES vs 11 ZN contracts.  If you are trading a 1mm$ account and wanted to put 1/3 of your margin to work on this leveraged trade, then you would sell 40 ES @ 1555 and sell 110 ZN @ 132-26 (thats 317k of 1/3 of your futures account as an example).  The trade to fade this move is to sell both (sell ZN and Sell ES), which is exactly what I've done.

Follow @govttrader on twitter to see what happens with NFP and next weeks long end (10yr and 30yr) treasury auctions.  Did the regime just change...or did the mkt just provide me a gift?   My expected timeframe for this trade is 1-2 weeks.  As always, my expectation for the future will determine when i actually exit this trade.

Disclosure:  I am not advising anybody do this trade with me...this is a leveraged trade, and short positions have the theoretical potential for unlimited losses.

govttrader out...

Tuesday, April 2, 2013

Stock vs Bonds (and trading other correlated assets)

I get asked a lot of questions about how i measure 10yr yields vs ES to get a RV valuation.  I think i've posted the details on this blog in the here i'm just talking about the basic premise...when you want to trade any pair based on a historical relationship.

When you think 2 securities are correlated..the first thing you normally do is can i tell if this is true?   The first route is to take prices, and graph them over some time interval (5 min, hourly, daily, etc...).  In this case, i took closing ES prices and 10yr yields.  I noticed that if i look from June 2012 to the present..there seems to be a tracking relationship...but with some deviation.  This is exactly what we want to see in a correlated pair...basic tracking...but with enough slippage that the pair mean reverts over time to some "fair value" (both towards and away gets both rich at times..and cheap at other times).  I know from experience that the treasury mkt tends to selloff or weaken between the start of the month and  long end supply (10yr and 30yr auction supply concession).  I also know that treasuries tend to richen towards the end of the month (the month-end extension trade).  When i looked at this pair graph, and overlapped these time frames..lo and behold...this tends to be true...not always to the exact date...but generally speaking.  So taking a few basic measurements and some time in excel...aong with a few assumptions that i had to verify from the data, i calculated that 4 ES contracts vs 1mm 10yr notes (or 11 ZN contracts) gave me the correct PnL graph to match the graph of the securities levels (after adjusting by a factor to put them in consistent terms).  You can do this yourself if you spend some time in excel with the historical data.  Then to answer the question "are treasuries rich or cheap vs stocks?" you can look at the graph and put the pair in historical context.  I take this a step further and add a "fudge factor" to center the bulk of the historical distribution at zero...the highest and lowest points on the graph are not exactly equal distant from zero...but pretty close.   Then i measure the distance from the point i've created as my "fair value zero" to the current mkt level...and  While you could just as easily be measuring the rich cheap of ES...the UST component tends to be the more volatile component...and thus the one i've chosen to base my measurements.  I could just as easily be saying that ES is 65 pts too rich vs where treasuries are trading right now...but since i more often just trade the bond leg on its own...i prefer to quote in terms of basis points (ie..if the 10yr were to selloff 13 bps right now..and ES didn't move...then i would say both are priced at fair value...alternatively..ES could selloff 65 pts and 10yr yields not move...and i would also say both are priced at fair value...given the last 9 months of this relatonship).  This is not rocket science...just lots of basic graph interpretation and some basic math...combined with my intuition of what i expect...backed up with 9 months of mkt history.

If you do this exercise yourself (be prepared to spend some time fiddling in excel and playing with fudge factors to define the relationship) should find that the spread between ES and 10yr yields looks almost like a sin wave (from geometry...sin / cosine / tangent...remember those days??).  That is a perfect example of a mean reverting relationship if you ask me.  And since this is really never get perfect.  If you look back pre-June 2012...this relationship breaks down.  I haven't spent the time to figure out what the relationship was back then...but i can say with certainty that the regime shifted in the 1st half of 2012...and the resulting regime gives us this nice relationship to trade.  I'll take it for as long as it lasts...and then when it breaks down (which it eventually must)..then i'll move on to something else.  Thus is the nature of trading....

I stopped graphing the relationship back in January...since i built a realtime trading system and i'm involved in trading this everyday, i don't need the graphs i stopped updating it...but if you do the work you should be able to reproduce what i have and then fill in the blanks for the more recent time period.

govttrader out...