The Perils of Shorting Bonds

It seems that now everyone has jumped on the short bond band wagon, i.e., short selling bonds or bond ETFs (such as TLT), or buying puts on these ETFs, or buying the inverse ETF TBT. The reason is the high inflation in the US that will eventually, perhaps sooner rather than later, cause the Fed to raise rates. Higher interest rates causes a drop in bond prices as the current bonds become less valuable.

Common sense warns that if everyone is on the same side of a trade, it is not possible to make money. Everyone cannot make money. Besides this general concept, John Mauldin mentions a chapter of a book by Luis Gave, "A Road for Troubled Times", in which he discusses the impending fall of the Euro. An oversimplification of the chapter is that since the advent of the Euro some European countries can no longer print money at will. They could print local currency, but cannot print Euros. As a result, their deficits are ballooning out of control. In fact, countries may go bust because they issued debt in Euros, which they cannot print. France's debt to GDP ratio has moved from 35% in Francs to 70% in Euros. These deficits are getting larger. Obviously this situation cannot last forever and something will break. Asian countries' currencies have also appreciated recently. This has caused spreads between countries to increase in Europe (the spreads between the strong countries such as Germany and the not so strong ones such as France or Poland. This increase in spreads causes all kinds of problems for the banks and puts pressure on their balance sheets.

The debt of these countries used to be top notch on the assumption that countries did not go bankrupt. This top notch rating is no more. So the big problem is for banks that invested in this debt, these loans were not marked to market.

Solutions are the elimination or collapse of the Euro (countries stop adopting it) with dire consequences for the European union, or the devaluation of the Euro. A devaluation of the Euro through lowering of interest rates will cause another flight to safety, i.e, to bonds.

How all this works out, and how it affect the US is yet to be seen. So far the ECB has firmly insisted that the rampant inflation is one of its top priorities, so lowering of rates is not being considered. The consequences of raising rates will be nefarious for certain countries. If the politicians have their way, this will not happen. The financial and liquidity crisis that affected the US is only starting in Europe, this time the problems are caused by governments whose debts can no longer be considered at book value. This will cause all kinds of mega loses for the banks.

Gave concludes that the credit crunch has started to make its way into Europe and banks will likely be reporting losses and write-downs, and investors will flee to the safety of bonds. We are in for very interesting times ahead, those shorting bonds should take this into consideration.