Trading Desk Notes July 27, 2019Submitted by Polar Futures Group on July 26th, 2019
The mean reversion trade: For the past few weeks I’ve been musing that the “irresistible force” that has moved all markets has been the aggressive repricing of future interest rate expectations since last November. We’ve had a HUGE rally in the bond market, MASSIVE flows into bond funds, record levels (>$13.7T) of negative yielding bonds, inverted yield curves, even Greek bonds trading through Treasuries...as markets anticipate a recession and much more Central Bank largess...which might just take us into MMT and/or never-never land where the Central Banks just buy all the bonds and that’s that. I’ve thought that this irresistible force may have gone too far too fast and was due for a “set-back” which would precipitate mean reversion trades across markets.
I’ve been cautious about executing mean reversion trades because I’m well aware that, 1) this has been a powerful bull market and its dangerous to pick tops in powerful bull markets and 2) a lot of really smart people think this bond rally has a LOT further to go (isn’t that always the case at market tops?)
They may be right on their call for much lower interest rates...but I think their time horizon is much longer than my short-term trading time horizon. They may also be wrong...I can imagine that we may see much higher interest rates in the future...because people will demand higher interest rates before they lend money to anybody. I know I don’t know what will happen over the next few years...and it doesn’t matter in terms of the short-term mean reversion trades I’m considering.
The core concepts of the mean reversion trades I’m considering are as simple as 1) the public buys the most at the top (thank you, Bob Farrell,) and 2) when they’re yelling you should be selling, and 3) positioning risk leaves some markets especially vulnerable.
The aggressive re-pricing of future interest rate expectations has caused some markets to become very “crowded trades” (positioning risk.) That doesn’t necessarily mean that it’s time to “take the other side” of the trade...but it does mean that it’s time to watch for signals that it’s time to take the other side of the trade...because a crowded trade is vulnerable to reversing quickly.
Last week this is what I wrote about the bond market...the very epicenter of the interest rate repricing trade...and the most crowded trade on the planet:
The end of the bond rally? Most runaway bull markets don’t just make a “Vee” shaped top and drop like a stone...there is almost always a failed bounce back following the initial break from the highs. That may be where we are on the bond chart if you see 157 as the top followed by an initial drop to 153. If the bounce back to 155 now rolls over and takes out 153 then we could see mean reversion trades showing up everywhere...not just in bonds.
If the bonds roll over and take out 153 that would be a signal that prices may be headed lower...that buyers may turn sellers...the target low based on a classical analysis of the 2 month head and shoulders pattern is ~149. If the market gets to 149 it will have broken the trend line from the 2018 lows...and could keep going lower.
A break in the bond market might also be a signal for the USD to rally...and if that happens the “positioning risk” in gold and Canadian Dollars (both markets have had a huge wave of interest rate inspired speculative buying) could send those markets lower.
I’ve been shorting the Canadian Dollar the past 2 weeks because it is a vulnerable “crowded trade.” Speculators have been aggressively buying CAD since mid-June as US interest rate premiums over Canada have fallen. Now that CAD is weakening those speculative buyers may turn sellers...exacerbating a decline.
The gold market has seen a wave of spec buying since the May lows with open interest rising by ~200,000 contracts (45%) to record levels. The last time open interest was at these levels was the Brexit summer of 2016 when interest rates were hitting historic lows. Over the next few months, as interest rates rose, gold fell ~$250 and open interest fell ~200,000 contracts.
My short term trading: I was short the S+P at the end of last week (the market closed last Friday at a 3 week low) but I closed the trade early this week at a breakeven. I covered my short WTI put when crude backed off mid-week gains. I added to my short CAD position and shorted EUR, JPY and gold this week. I’ll be looking for opportunities to take more mean reversion trades.
The most important trading rule...that gets broken all the time:
I’ve been trading futures since the mid 1970’s and I “know for a fact” that trading is not a game of perfect. I’ve watched 100’s and 100’s of traders...retail, corporate and institutional...lose millions and millions of dollars...while a few people were hugely successful. The one thing that the people who lost money had in common was that they let losing trades run too long and they took small profits too quickly. Their behavior was exactly the opposite of the old Wall Street adage, “Cut your losses short and let your winners run.”
I remember talking with a very successful bond trader in a bar near the Chicago Board of Trade many years ago, long before online trading killed the floors, and one of the things he said that really rang a bell for me was that, “Nobody could hang onto a winning trade like Ricky Barnes.” He was shaking his head in admiration as he said that...like it was unbelievable that a guy could do what Ricky had done so many times.
I’ve been a huge Michael Lewis fan ever since I read Liar’s Poker (three times!) back in 1989. His 2010 book The Big Short celebrates a handful of traders who made huge profits by sticking with their positions because they had strong opinions about what “had” to happen in the markets. It’s the kind of story people love to read: some good guys become convinced that they “see what’s coming,” they make big bets on their opinions, hang onto their trades despite all kinds of setbacks and abuse and come out huge winners. What’s not to like?
Maybe somewhere somebody wrote a book about a bunch of guys who had a vision of the future, made big bets that they were right and everybody else was wrong, hung onto their positions despite all kinds of setbacks and abuse and went down with the ship...because they were wrong. Something tells me that if there was such a book it probably wasn’t a best seller.
If you initiate a trade because you think the market is wrong you set yourself up for being wrong...and staying wrong...which can get really expensive. For instance, if you believe “corn is a steal at these prices,” you will have a hard time cutting your losses if corn keeps falling. If you buy corn because you notice that, “corn looks like it wants to keep going up,” you will have less trouble cutting your losses if it rolls over and starts to go down. Why will you have less trouble? Because it’s just a trade...not a challenge to your ability to assess value.
Successful traders find a way to participate in the market that suits them. What works for one guy won’t work for another. Probably the worst thing that can happen to a new trader is to be in the right place at the right time...make a lot of money...and truly believe that it was because he was so damn smart. You just know he’s going take a licking.
Weekend smile: Swiss government bonds of all maturities now have one thing in common: a negative yield. The Swiss government can now borrow money for 50 years and be paid to do so.
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