The bond market took a beating when the September jobs report came out last week. But behind the scenes, I think there’s more to the story. And it has dangerous implications for your investments …
The monthly employment report is always a biggie for bonds. Reason: It’s the best gauge of our country’s overall economic health. The report tells us how many jobs were created, the national unemployment rate, hourly wage growth, and more. So at 8:30 a.m. on “jobs Friday,†anything can happen.
Last week’s report was weak on the surface. The U.S. economy created just 51,000 non-farm jobs. That was down from 188,000 in August, and the least since last October, right after Hurricanes Katrina and Rita. Manufacturing, retail, and temporary employment categories all shed jobs.
In theory, that should be good for bonds. The reason: Softer economic news makes the Fed less likely to raise short-term interest rates. It also eases bondholders’ longer-term inflation concerns, allowing them to feel comfortable holding 10- and 30-year Treasuries. So right after the numbers came out, 10-year Treasury note futures prices shot higher.
But within minutes, the rally failed. By the end of the day, prices had posted the single-biggest daily percentage loss in more than 14 months. The next trading day, they fell again. And they dropped even further the day after that.
Fundamentally, there were at least two reasons the report wasn’t as favorable as it looked at first glance:
The unemployment rate dipped slightly, from 4.7% to 4.6%.
Wage pressures continued, with average hourly earnings gaining 4% year-over-year for the second month in a row.
But should that have triggered such a nasty rout? I don’t think so. Instead, something else is contributing to wilder-than-normal swings in the markets …
Derivatives and Other
Leveraged Investments
Buying a stock or a bond is pretty straightforward – you give your broker some money and you receive an investment worth that amount in return. Your gains or losses are based on the original amount you invested.
But what if you want to control a large amount of stocks or bonds without putting up all the money? In that case, you can use leverage, which allows you to participate without committing as much cash up front.
Chances are, you’re using leverage in another arena – and don’t even realize it. Case in point:
When you put down 20% in cash on a $500,000 house, and take out a mortgage for the rest, you’re using leverage. You’re not paying the whole purchase price out of your own pocket – you’re putting up a small portion of it and borrowing the rest.
Let’s say that within a year, the home’s value shoots up 10%. If you sell it, you’ll get $550,000. After you repay the $400,000 you owe, you’ll still have $150,000 left over.
With your initial investment of $100,000 (the down payment money), you’ve made a profit of $50,000. That’s a 50% gain – far greater than the 10% appreciation that your house posted.
So, using leverage is essentially betting with borrowed money. In the financial markets, derivatives are very popular classes of leveraged investments. These investments are based on an underlying asset, such as a stock or bond. Their prices rise and fall along with their underlying asset.
The major difference: The leverage MAGNIFIES the significance of any move in the value of the underlying asset.
When used properly, derivatives can help maximize gains with a minimal initial investment However, when used improperly, they can wreak havoc …
The Downside of
Big Money Betting
With Derivatives 
I’ve been doing some research on leveraged investments for next month’s Safe Money Report. I can’t share all my findings — that wouldn’t be fair to our paying subscribers. But here’s what I can tell you …
- The amount of derivatives in the financial system is mind-boggling. It’s not $285 million … or even $285 billion … I’m talking about a whopping $285 TRILLION in over-the-counter derivatives outstanding around the world as of December 2005. That’s up almost 14% in a year, and 45% in two years.
- Derivatives tied to interest rates are far and away the biggest part of the market. The Bank for International Settlements estimates they account for about 75% of the market. And in the U.S., they make up 83% of the market, according to the Office of the Comptroller of the Currency.
- A huge chunk of these contracts are what I call “financial dark matter.†They don’t trade on regulated exchanges. Instead, they’re just agreements between banks, insurance companies, and/or hedge funds.
The upshot is this: More and more derivatives are floating around out there, magnifying each market move. At the same time, it’s very difficult to know who’s holding what, or who won or lost with any change in interest rates.
What we DO know is that high-flying hedge funds are some of the biggest whales in this global casino. Consulting firm Greenwich Associates says hedge fund trading in bonds and derivatives has more than doubled in the U.S. in the past year.
One major hedge fund, Vega Select Opportunities, reportedly just suffered $400 million in redemption requests from investors. Why? The fund got crushed in September by betting that bond prices would decline. Bloomberg reported that the fund lost almost 12% of its capital in one week when U.S. Treasury yields fell instead of rose.
Even the regulated markets are awash in high-powered interest rate bets. Take a look at the chart. It shows trading activity in 10-year Treasury note futures among large speculators. These are the hot money players using leveraged bets to try to make big profits from relatively small bond market moves.
In the week ended October 3, a lot more money was betting that 10-year bond prices would rise. These speculators were holding 520,871 contracts more than the people betting against bond prices. Not only was this difference up 9.5% from a week earlier, it was also the single highest level in recorded history — almost twice the previous record from last March.
Now, in and of itself, all this hot money and leverage doesn’t mean Treasury prices will fall. And it doesn’t work perfectly as a timing signal, either.
But historically, whenever lots of people are all betting in favor of rising prices – with ever-increasing amounts of borrowed money – it spells trouble. Things can blow up quickly and spectacularly.
Given the risks out there, here are two steps to consider taking:
#1. Remain cautious in your approach to bonds. I’m not a big fan of long-term Treasuries. I’d rather stick to short-term instruments — 3-month bills, 6-month bills, or at most, two-year notes.
#2. Don’t make big, high-risk bets right now. I’m especially talking about stocks and high-yield bonds. Right now, these assets are priced as if everything is going to work out perfectly. That means an unforeseen shock could come out of the blue and send them reeling.
You can’t know what the trigger will be in advance. But you can prepare yourself by reducing the risks you take, booking some profits, and abstaining from big bets.
Until next time,
Mike
P.S. If you’re interested in learning more about the dangers that derivatives pose to the financial markets, you can sign up for Safe Money Report here.
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