The prospect of a bear market in bonds has been a regular source of excitement for us, but we do our best to leave predicting the future up to the experts. And in our experience, no one knows bonds quite like the fixed-income expert, CEO and CIO of 2100 Xenon Jay Feuerstein. Mr. Feuerstein’s resumé is definitely impressive – after studying at the famed Chicago School of Economics (which produced the likes of Milton Friedman and Eugene Fama), Jay has spent his entire career trading bond futures. Jay was even involved in the creation the first bond future contract in the late 1970’s… in other words he knows what he is talking about. We were pleased to have an opportunity to hear him today at the annual 2100 Xenon breakfast presentation at the University of Chicago Booth School of Business discussing interest rates and the potential for a bond bear market.
The Future of Bonds…
Today’s presentation was a macro discussion on the potential for higher interest rates and how to profit from them. In summary, Jay believes the rates are set to go higher sometime in the next couple of years, resulting in that bond bear market we’ve been waiting for. Mr. Feuerstein is the first to admit that the best trade in the past 30 years was to buy a bond in 1980 and watch it compound at an annual rate of 14%. Of course, there have been quite a few volatility spikes over the past 30 years that would have made even the heartiest bond bulls question their decision to be long. But if you had the guts to do it, staying long bonds has been the best trade of the past quarter century. The question now is twofold: where do rates go from here, and how can investors profit?
Without delving into the particulars (Jay and his team are the experts on this stuff), the team at 2100 Xenon believes that improved economic conditions – and the potential for inflation on the horizon – mean that long term rates are set to rise. Meanwhile, short term rates remain stagnant due to the Fed’s recent policy decisions. So how does one profit from a rising long term rate? The easy answer seems to be sell bonds and get ready to enjoy the ride back down the hill of the rate roller coaster… but as Jay likes to point out, there’s many a trader who has gone to his grave trying to call the top of the market. The better trade in Mr. Feuerstein’s opinion is to short 30 year bonds with the expectation that inflation concerns will force bonds lower, while buying the shorter-term rates (2 years) as a hedge against Fed policy.
But Will Trend Followers Rejoice?
All of which leads to our main concern: will trend following strategies profit from rising long-term rates? And this is where we diverge from the folks at 2100 Xenon. Even though Jay is a systematic trader and trend following makes up 50% of this portfolio, he fears that trend following CTAs will have a hard time catching the move. When the selloff in bonds arrives, he predicts it will be extremely quick – to the tune of thirty-five handles in 30 days. Based on today’s bond price of 144 this would be a 25% move in just one month! Jay sees this kind of move as the worst-case scenario for many trend followers, who would be left on the sidelines waiting for their moving averages to catch up to the market before entering short… but this is where we see things a little differently.
We’re not convinced that trend followers couldn’t catch a sharp move down in bonds. For one, the rate of change in 30 year bonds is already negative on a 6-8 month basis. In other words, there’s no “catching up” to do before trend followers initiate short positions, because the averages are already heading down. In fact, some trend followers are already short based off the sell off from last year’s highs. And we’ve seen trend followers profit from sharp moves before – for instance, there was a 28-handle (a handle is one full point, 144.20 to 145.20, for example) move in 41 days in 2008 which trend followers were able to benefit from (Disclaimer: past performance is not necessarily indicative of future results). In short, it’s not sharp moves trend followers worry about, it’s sharp reversals in the trend. Of course, sharp reversals are more likely after sharp moves.
We always enjoy getting Jay’s perspective on the bond market and how it relates to his 2100 Xenon Fixed Income Program. For our money, no one knows bond futures better than Jay, and we certainly hope his prediction of a bond bear market holds true. But when it comes to trend following, we still believe that a selloff would be just what managed futures has been waiting for.
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