Executive summary

In this most recent report, Rich looks at different markets (i.e., Japanese Yen and British Pound), compares how policy maker interventions impact the markets, and develops different spread trade ideas based on catalysts he sees in the market. 


Intervention (noun)

: the act of interfering with the outcome or course especially of a condition or process (as to prevent harm or improve functioning)

: the interference of a country in the affairs of another country for the purpose of compelling it to do or forbear doing certain acts

: an occurrence in which a person with a problem (such as a drug addiction) is confronted by a group (as of friends or family members) whose purpose is to compel the person to acknowledge and deal with the problem

-        Merriam-Webster dictionary

In the past month or so, we have seen many markets globally continue to struggle. In some places, markets have become so unhinged that authorities have had to step in and arrest the volatility in the market. The two that are most top of mind are the Bank of Japan in the Japanese Yen FX market and the Bank of England in the UK Gilt market.

As we can read from the above definition, the intervention we are seeing in the markets by the BOJ and BOE in the past month would appear to fall under the first definition of intervention. Authorities are attempting to ‘prevent harm or improve functioning.’  However, one might argue that the markets, the bond vigilantes, are also intervening in the markets. Bond vigilante is a term coined by Ed Yardeni in the 1980s to identify bond traders who sell large amounts of bonds to signal a distaste of policies. This might fall under the second definition above, where the market is interfering in the ‘affairs of another country’ for the purpose forbearing certain acts. These acts might be considered the profligate spending and monetization of debt that has possibly occurred across much of the developed world.

In his newsletter “Strategic Bond Investor,” Tony Crescenzi, a portfolio manager at PIMCO, suggests “indebted nations have reached a Keynesian Endpoint:”

“The reawakening of bond market vigilantes suggests that developed nations have reached a Keynesian Endpoint, where practical limits to the use of debt become apparent. The acceleration in inflation may signal attainment of that limit, with the surge probably linked to the extensive use of debt that followed the onset of the pandemic. 

More recently, a violent market reaction to a planned fiscal expansion in the UK may signal the existence of a Keynesian Endpoint across the pond, with investors expressing dismay via heavy selling of gilts and pounds. Still more evidence of investor loathing at fiscal follies arrived this month when euro bond prices plunged in reaction to news that Germany may be open to a fresh round of EU bond issuance. “

-        Tony Crescenzi, The Strategic Bond Investor newsletter

If we look at a table of the biggest possible offenders, and biggest potential sources of volatility as bond vigilantes fight back, Japan and the UK are at the top of the list, though each is far from being the only offenders on the list. You can see that it is not just the debt to GDP that is outstanding, but it is also the budget deficit as a percent of GDP. Where we see both numbers giving a yellow (if not red) warning sign, we need to take cover.

Post the Great Financial Crisis, Carmen Reinhart and Kenneth Rogoff argued in their book, This Time is Different, that countries would embark on financial repression to force financial institutions into buying sovereign debt, enabling governments to print and spend their way out of an economic hole.

How does this work in practice? I am not going to go into great detail, but in my class I speak to my students about how financial institutions are compelled by regulation to buy sovereign debt:

  • Under the Basel III regulation, post the Financial Crisis, banks are required to hold a larger percentage of high-quality liquid assets (HQLA) on balance sheets
  • Similarly, under the Solvency II regulation, insurance companies face a similar mandate. This particularly affects European and Asian companies
  • Pensions funds this century have been required to do asset-liability matching. With aging populations, this means more bonds must be bought.

Source: Richard Excell class notes

As suggested, real rates went negative in the immediate post GFC world. For all of 2014-2019, real rates were positive but only marginally so. In the aftermath of Covid-19, authorities found it necessary to drive real rates into negative territory again.

Image 1: US 10-year real interest rates embedded in the TIPS market

These negative real rates drove the term premium for bonds persistently lower for the entire post-GFC period culminating with a negative term premium in the entire time post-2018. Time value of money is a foundational principle of finance. It is logical that investors should and have demanded a higher rate of return for locking up money over a longer period of time. However, this repression led to investors actually demanding less interest rate for locking up money longer.

Image 2: Term premium embedded in the 10-year Treasury bonds using ACM model

This distortion of the markets led to a bubble. It was not a bubble as many tend to think of bubbles, typically in the riskiest parts of the market. It was a bubble in duration, as financial institutions had to rush to buy longer and longer bonds for regulatory reasons. This was magnified when during the early days of Covid-19 central banks, like the Federal Reserve, also stepped in to directly buy not just Treasuries but also mortgage-backed securities and corporate credit. As the central bank bought these duration assets, other investors were squeezed to buy duration wherever they could find it. We ultimately saw a peak in the amount of negative-yielding debt in the world at almost $19 trillion (in white). The Barclays Aggregate followed suit and duration in other asset classes, from cryptocurrencies to Nasdaq, high growth tech stocks also followed along.  When central banks started to raise rates globally, this bubble in duration started to have the air let out. We first saw the amount of negative-yielding debt roll over, then the Barclays Aggregate, then cryptocurrencies (i.e., Bitcoin), and finally tech stocks (i.e., NDX Index).

Image 3: Negative yielding debt, Barclays Aggregate, Bitcoin and Nasdaq Index

The popping of this bubble in duration, driven by higher-than-expected inflation, supply shocks, and central bank rate hikes has caused a world of pain for risk parity strategies (in blue) and liability-driven investing strategies (in white). Both rely on the negative correlation between stocks and bonds. In an inflationary period, stocks and bonds become positively correlated. You can particularly see the price action of Liability Driven Investing (LDI) below. You can see why there was a margin call in the UK Gilt market.

Image 4: Risk parity and Liability-driven investing returns in 2022

The BOE intervened around the end of Q3 as yields were spiking and the GBP/USD currency pair (inverse here) was collapsing. The BOE first intervened on September 28 (red arrow) and then on October 6 (green arrow), told the market the intervention was only for a limited time and the LDI funds better get their house in order.

Image 5: UK 30-year Gilt yields and GBP/USD FX rate

The UK was not the only place where we saw intervention. As discussed in previous Excell with Options blogs, the Bank of Japan had begun an active strategy to import inflation into its country when it re-affirmed its yield curve control strategy, pegging 10-year Japanese Government Bond (JGB) yields near zero while the Fed was hiking rates and taking 10-year Treasury yields higher. The escape valve for this disparity in rate policies is the exchange rate, and that is exactly what we witnessed.

Image 6: Difference between 10-year Treasury & JGB yields vs. USD/JPY FX rate

This is not a recent phenomenon. The interest rate differential between Japan and the U.S. has been a good predictor of the direction of USD/JPY for the better part of this century. The only dislocations we have seen between then were: 1. When the Three Arrows policy was first announced by the Japanese government in 2014 and the currency weakened for some time, coming back into line 2. When there was a taper tantrum in the U.S. and U.S. bond yields spiked, only to come back into line 3. When the Fed was embarking on pinning nominal and real rates much lower as a way to stimulate the economy around Covid-19.

Image 7: Difference between 10-year Treasury & JGB yields vs. USD/JPY FX rate long term

The spike in USD/JPY was predictable. The magnitude of the move took many off guard and this led to the BOJ intervening once on September 22 (first arrow) and then again on October 21 (second arrow). Both had a major impact on the day of intervention, but neither are expected to have a lasting impact.

Image 8: USD/JPY Ichimoku cloud chart with BOJ interventions indicated

Part of the reason the market may be interpreting the interventions quite differently is because of the other aspects of policy going on in each country. In Japan, per Kyodo news, authorities are suggesting the intervention was solely to reduce the excessive volatility in the currency pair, which had become ‘problematic,’ according to Prime Minister Kishida.  He will work with the BOJ to take appropriate steps. Right or wrong, the markets interprets this as saying they are fine with the direction but not the pace of the move.

Prime Minister Fumio Kishida said in parliament on October 18 that the yen's rapid depreciation is "problematic" and the government will work with the Bank of Japan in taking appropriate steps. BOJ Governor Haruhiko Kuroda rejected an opposition lawmaker's demand that he step down over years of easing by the central bank that has weakened the yen but failed to achieve its inflation target.

However, in the UK, there has not only been intervention by the BOE, but there has been a wholesale change of government. Prime Minister Truss and Finance Minister Kwarteng are out of office in about a month and Truss’ challenger, Rishi Sunak, with a very different set of policies, is coming in. Axios Macro, October 24, 2022

Thus, as traders, we might take this all in and think a few things:

  1. Both the UK and Japan have too much debt and too big of a negative budget
  2. Bond vigilantes are punishing the currencies of bonds of those markets
  3. Both countries are intervening in the markets
  4. Japan is continuing a status quo policy while England is changing course
  5. Thus, we might expect a different path forward for each market

As always, I like to start my trade idea with a look at the CVOL measures. As you can see for both JPY/USD and GBP/USD, we are at elevated volatilities though not at the highest levels of the year. Implied volatilities may be a bit pricey.

Image 9: CVOL chart of FX implied volatilities

If I first think of JPY, I can see above that there could be some continued pressure on the yen. Treasury vs. JGB spreads are showing no signs of abating.  The BOJ has intervened in order to slow the pace of the move in USD/JPY, but no steps have been taken to ultimately alter its course. The market has challenged the BOJ intervention level (145 USD/JPY) one time already and has been successful. It is therefore likely the market will challenge the latest level (151 USD/JPY).

Leveraged accounts continue to use the yen as a funding currency as we can see from the latest Commitment of Traders report that shows a consistent net short position. This position had been shrinking into the first intervention but has actually gotten more short again after that intervention.

Image 10: Commitment of Traders report for JPY/USD futures

The term structure of implied volatility is downward sloping as we might expect where there is intervention activity in the market.

Image 11: JPY/USD implied volatility term structure

Though we can also see that implied volatilities are above the historical volatility. Perhaps the BOJ is having the intended effect of reducing the pace of the move higher.

Image 12: JPY/USD implied volatility vs. historical volatility the past year

We can see in the matrix below that yen call volatilities are actually higher than put volatilities, suggesting the market may be more nervous of a move higher in the yen (lower in USD/JPY) than the converse. This is something we can lean on.

Image 13: JPY/USD implied volatility surface

We can see this more clearly here if we zero in on the November expiration date.

Image 14: Implied volatility skew for November expiration

Taking this all into account, I would sell a yen call spread relying on the elevated implied volatility on the yen call side. The trader could use this premium to buy a yen put, expecting a continued move higher in USD/JPY above the intervention levels of the BOJ.  The USD/JPY equivalent strikes I am using are selling a 144-140 yen call spread to buy a 151 yen put. You can see I am buying a 16.50 implied and selling an option on a 20 implied. I am able to do this spread, which gives me limited potential loss and unlimited potential gain for zero cost.

Image 15: Expected return chart for short yen call spread vs. long puts

If I look at the GBP market, I find I am leaning toward an opposite expression. First, in looking at the GBP chart, we can see a series of higher lows. In addition, we are approaching the previous support, which has become resistance, at 1.1500.

Image 16: GBP/USD technical chart

Leveraged accounts have reduced the net long in GBP but have not gone short. There is some recent stability in positioning here.

Image 17: GBP/USD futures Commitment of Traders report

GBP implied volatility term structure is also downward sloping. It is very noisy around the catalysts of UK and U.S. elections and a Fed meeting. However, GBP implied volatility is largely elevated particularly in the front part of the curve.

Image 18: GBP/USD implied volatility term structure

Implied has recently fallen below realized volatility, perhaps suggesting that market makers are finding it more difficult to cover their theta costs in the market. This suggests a continued fall in implied volatility perhaps. It at least suggests that gamma could come for sale.

Image 19: GBP/USD implied volatility vs. historical volatility

Unlike the JPY market, traders are putting a higher premium on GBP downside instead of the upside. In fact, the GBP upside trades at a discount to the at the money volatilities.

Image 20: GBP/USD implied volatility surface

We can see that more clearly when we zero in on the November expiration date.

Image 21: GBP/USD implied volatility skew for November expiration

So, I would do the opposite trade as we did in the JPY. A trader could sell a 1.100 -1.0750 GBP put spread and use the proceeds to buy a 1.1750 call, struck above the resistance levels at 1.150. Again, we are taking advantage of not only high implied volatility as seen in the CVOL, but higher implieds on the put side vs. the call side of the ledger. This trade can also be done at zero cost.

Image 22: Expected return for short GBP put spread vs. long call spread

Two markets, two interventions, two trade ideas. The biggest difference is what is happening outside of the interventions by policy makers, but also what the market is nervous about (yen upside vs. GBP downside). We can build a case for the opposite occurring and therefore lean on the market pricing to develop ideas that are complimentary. If the bond vigilantes continue to pressure certain countries, the gains in the yen trade should insulate any losses in GBP. If the market has a risk-on, short-covering rally, the gains in GBP should cover the losses in yen.  There are a lot of headlines and a lot of catalysts. As traders, we need to sort through these stories for the opportunity to construct good reward to risk ideas.

Good luck trading.

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