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Get Ready for the Greatest Trade in History

Interest-Rates / International Bond Market Jun 08, 2015 - 02:55 PM GMT

By: ...

Interest-Rates William Patalon writes: In Wall Street lore, it's known as the "Greatest Trade Ever."

It's also known as "The Big Short."

In 2006, John Paulson was a relatively unknown hedge-fund manager – just another face in the crowd.

But Paulson was smart, observant – and had the courage of his convictions.

He understood something that most others didn't even suspect. The U.S. housing "boom" was a sham. Especially in the area of "subprime" mortgages.

Paulson was schooled in mergers and acquisitions (M&A), so mortgages weren't at all his bailiwick.

But he believed the mortgage market was poised for a free fall.

He wanted to make a big bet against this market – a "big short." He just wasn't sure how to make that wager…

Paulson and several other renegade investors like Michael Burry and Jeffrey Greene made big bets against the risky mortgages using complex financial instruments known as "credit default swaps," or CDS.

Initially, the trade went against these mortgage doomsayers – putting them tens of millions of dollars in the red as the mortgage market continued to rocket. But instead of closing the trades and accepting the losses, Paulson and these few others effectively doubled down.

By the middle of 2007, the credit markets stumbled and then careened downward.

As the year came to a close, it was clear that Paulson had pulled off "The Greatest Trade Ever," having earned $15 billion for his firm – a total that dwarfed investing icon George Soros's billion-dollar currency play of 1992.

Over time, the Paulson trade gained a second moniker – one besides "The Greatest Trade Ever."

Thanks to a best-selling book about the mortgage crisis that was written by Michael Lewis, the Paulson trade became known as "The Big Short."

I'm telling you this story for a reason. An even "Bigger Short" may be on the horizon, and I'll tell you how to profit from it…

Our Expert Makes a "Big Call"

Capital Wave Forecast Editor Shah Gilani and I were talking about Paulson and his "Big Short" the other day.

For a good reason.

Shah said another trade is brewing – one that he and a few other select experts are predicting will be "The Bigger Short."

I'm talking about the looming collapse of the global bond market.

Shah just told his readers how to play it. And now he's sharing that strategy with us. "Bill, what's important to understand, for starters, is that the bond market – meaning the market for all bonds all around the world – dwarfs the size of all the stock markets in the world combined," Shah explained.

"If you look at the averages over the past quarter century, the bond market has been 79% larger than the stock market – and in 2012, was 104% larger. Over the last eight years, because central banks have manipulated interest rates down to artificially low levels, bond prices have been on the march. Higher bond prices and low interest rates have prompted investors to move out of bonds and into stocks. In fact, bond prices have risen so high that trillions of dollars' worth of bonds actually have negative yields, or interest rates."

Negative yields means, in effect, that investors are loaning money to governments – and are paying the governments for the right to do this.

According to the BlackRock Investment Institute, there are $5.3 trillion worth of bonds today with a negative yield; 60% of those bonds, or $3.18 trillion worth, are European bonds.

There's a reason for this.

The European Central Bank (ECB) has torn a page out of the U.S. Federal Reserve playbook and is running a "quantitative easing" (QE) strategy – one where the ECB is buying securities from investors to pump cash into the system.

But because the ECB pretty much "telegraphed" its intent, investors decided to "front run" the central bank by purchasing bonds in the market first. And since those investors were planning to sell the bonds to the ECB, they were willing to "pay up" – figuring they'd cash out at sale time. They even used "margin" – borrowed money – in many cases to make those purchases.

The risk, though, is that the bond market craters before they can sell those bonds, meaning they'll have a big loss on their hands.

All of this helps set the table for an epic collapse.

"In a classic 'front-running' move, speculators – knowing the ECB was going to start buying bonds – paid higher prices for trillions of dollars' worth of bonds, which drove yields into negative territory," Shah said. "It wasn't that investors were willing to accept negative yields; they believed the ECB would eventually buy them at those inflated prices. In March, the ECB started buying about $60 billion worth of those bonds a month."

On paper, that's a nice trade.

But there's a problem.

"Just do the math here and you'll see the issue," Shah explained. "If the ECB buys $60 billion of bonds a month from the banks and speculators who bid them up and have nice paper profits on their inventory, we're talking about central-bank purchases of about $720 billion a year."

Say the ECB ends up buying $1 trillion worth of bonds at the current "bubble prices" it is paying.

That would still leave about $2.18 trillion worth of negative-yielding bonds in the hands of the banks and speculators who bid them up and are now sitting on paper profits.

(It's called a "paper profit" because these investors still own the bonds, meaning the gains they have are "on paper" – they're accounting gains.)

Until the traders actually sell the bonds and "realize" (lock in) them, they are profits on paper only.

"So as the ECB drops $60 billion a month on bonds whose prices are grossly inflated, all the holders of all the rest of the trillions of dollars' worth of bonds have to sit on their inventories of bonds, hoping and praying nothing goes wrong," Shah told me.

Unfortunately, there's a lot that can go wrong.

Troubling Signs

There's all that leverage – the money those investors borrowed to buy the bonds. Any major bond-market decline could trigger bigger bond sales – causing bond prices to really tank.

Then there's the threat that the Fed will make good on its plan to eventually raise interest rates here.

There's also a liquidity issue – the bond markets just aren't as "deep" as they used to be.

In a recent Bloomberg Business analysis, big traders said the U.S. government debt market has lost a significant amount of its "depth," or ability to handle big trades without having prices move. A year ago, traders said they could move about $280 million worth of U.S. Treasury bonds without causing prices to move. Now it's only $80 million, JPMorgan Chase & Co. (NYSE: JPM) says.

The risk is actually even higher than most people know.

The "Other" Flash Crash

Most folks remember the stock-market "Flash Crash" of 2010 – when the Dow Jones Industrial Average plunged 998 points, or about 9%, in 36 minutes. That was the biggest intraday decline in the Dow's history.

But there was another Flash Crash, an even bigger one – and most retail investors know nothing about it.

This "other" Flash Crash hit the U.S. Treasury bond market back on Oct. 15.

Bond yields plummeted in an "unprecedented" manner, said JPMorgan Chase CEO Jamie Dimon – who described it as "an event that is supposed to happen only once in every 3 billion years."

In the Treasury Flash Crash, what actually happened was a huge price rally – meaning the crash was in yields.

"From 9:33 a.m. to 9:45 a.m. the morning of Oct. 15 – a scant 12 minutes – the yield on the 10-year plunged from 2.15% to 1.86%," Shah recounted. "That's huge. Thanks to the 'bad-news-in-the-economy-is-good-news-for-bonds' backdrop, the disappointing economic reports meant the Fed wasn't going to lift rates, which meant it made sense for investors to buy existing bonds. At the same time, the 10-year yield was at 'support,' meaning the yield had come down enough that traders were betting it wouldn't go any lower. In fact, traders were expecting better economic news and yields to start rising."

Treasury bonds are traded by every big bank in the world: The market is gigantic – about $12.5 trillion, according to the recent Bloomberg analysis.

But the Flash Crash shows there's a liquidity issue. And experts say there are similar "depth" issues with other bond markets.

Here's what that means: In a big sell-off, the lack of depth could dramatically steepen any decline.

"Bill, back in late April, Bill Gross, who cofounded Pacific Investment Management Co. (PIMCO) and is now a bond-portfolio manager with Janus Capital Group, tweeted that 'German 10-year bunds [are the] short of a lifetime. Better than the pound in 1993. Only question is the timing'," Shah recounted. "Doubleline Capital founder Jeff Gundlach, the other bond king, agrees and is betting on a European Union bond implosion."

Billionaire Paul Elliott Singer, founder of the massive hedge fund Elliott Management Corp., calls the opportunity to make money on the European bond-market collapse "The Bigger Short."

The bottom line: Shah believes we're looking at a big bond-market collapse. The only part he can't predict with certainty is the timing.

But he can give you a strategy to profit.

The "Bigger Short" Profit Strategy

As Shah explained to me, "when the European bond bubble breaks, you want to be short European bonds, short European stocks, and short the euro against the U.S. dollar. You'll also want to buy U.S. Treasuries, as their price will skyrocket in a 'flight-to-quality' trade."

Here are four trades to help you do that.

To short European bonds, Shah recommends buying "Puts" on the iShares PLC Markit iBoxx Euro High Yield Bond ETF (LON: IHYG).

"There aren't good, liquid exchange-traded funds (ETFs) that give us the direct exposure we want to short European government bonds," he said. "And shorting IHYG is a problem because it has a 4.29% dividend yield. That's why I like buying long-term puts on IHYG here, but especially if its price is above $110."

To profit from falling European stocks, Shah recommends shorting the iShares MSCI EMU ETF (NYSE: EZU), which holds stocks in all the European Economic and Money Union (EMU) countries.

When the collapse happens, the EMU's currency – the euro – will collapse, too. So he recommends buying the ProShares UltraShort Euro (NYSE: EUO). This is a "leveraged" ETF, meaning it moves two times as fast as the euro trades against the U.S. dollar. Buy it when interest rates start ticking up in Europe.

Then there's the U.S. market.

"Lastly, in a panic based on a European bond-market implosion, money that comes out of European bonds and exits panicked markets will rush into the safe haven of U.S. Treasuries," he said. "I expect Treasuries to soar on a European implosion. A great way to play rising Treasury prices is by buying the iShares 20+ Year Treasury Bond ETF (NYSE: TLT)."

When the dust settles, this "Bigger Short" could take over the title as "The Greatest Trade Ever."

More from Bill

As Executive Editor, Bill has 24/7 access to our editors and their best, high-profit ideas. And he sends those recommendations to his Private Briefing readers every day. As a result, they've enjoyed 192% double- or triple-digit winners since launch. Click here to learn more…

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Money Morning/The Money Map Report

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