The Bond Market’s ‘Ground Zero’ – How to Cash in on the New ‘Greatest Trade Ever’

by Shah Gilani, Editor, Wall Street Insights & Indictments

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: That the U.S. housing “boom” was a sham.

U.S. housing was especially weak 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 CDSs.

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 Michael Lewis’ best-selling about the mortgage crisis the Paulson trade became known as “The Big Short.”

I’m telling you this story because a similar trade is brewing – one that I predict will soon go down in history as “The Bigger Short.”

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

You might think that “collapse” is too strong a word. As you’re about to see, it is not.

To really grasp what’s behind this impending financial calamity, let me lay out a few facts you need to know about bonds and the bond market.

$2.8 Trillion Bond Casino

The bond market – meaning the market for all bonds all around the world – dwarfs all of the stock markets in the world combined. Over the past quarter century the bond market has been on average 79% larger than the stock market. In 2012 it was 104% larger.

For the most part – and most people who aren’t economists or capital-markets specialists don’t know this – stocks “trade off bonds.” That’s a shorthand way to say that when interest rates rise (and bond prices fall), bonds begin to look like a better investment than stocks.

That’s because, generally speaking, an investor would rather own a promissory note that pays a decent rate of interest compared to a speculative stock.

Over the last eight years, because central banks have manipulated interest rates down to artificially low levels, bond prices have been on the upward march. And, revealing the flip-side of the principle I just mentioned… higher bond prices (and lower 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.

A negative yield means, in effect, that investors are loaning money to governments and at the same time paying the governments for the right to do so.

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

Prices and Yields: The “Push-Me-Pull-You” of Bonds

Here’s an easy example that will show you how and why bond prices and bond yields move in opposite directions.

Bonds, as you know, pay interest. And for bonds, price and yield are inversely correlated. That’s important to understand.

Let’s say you bought a 10-year bond with a 2% “coupon” (that’s the interest) and paid $100 ($100 is “par”) for it.

Sometime later, the issuer of your bond sells the same 10-year bond with attached interest of 3% and a price of $100.

That means the price of your bond will change.

Here’s why. Someone who comes along and wants to buy a 10-year bond now has a choice: to buy your bond or to buy the new 10-year with the higher coupon.

Obviously, he’d buy the new bond for $100 to get more interest. So, in order for you to be able to sell your bond, you will have to lower the price to some level where the amount someone pays is so much less than $100 (in other words, a discount from par) that the amount he pays (invests) turns the 2% yield into a 3% yield.

To give you some perspective, the price we’re talking about here is around $66.67.

Here’s why.

The European Central Bank (ECB) has torn a page out of the U.S. Federal Reserve playbook and is pursuing 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 first purchasing bonds on in the market so they’d have them to sell once the ECB was ready to buy.

And since those investors planned to sell the bonds to the ECB, they were willing to “pay up” – figuring they’d cash out at sale time. In many cases they even used “margin” – borrowed money – to make those purchases.

It was a classic front-running move. Speculators, certain the ECB would start buying bonds, pay higher-than-normal prices for trillions of dollars’ worth of bonds, which drives yields into negative territory.

It wasn’t that investors were willing to accept negative yields. It was that they believed the ECB would eventually buy those bonds at inflated prices.

On the surface, that looks like a great trade. Even a “sure thing.”

But…

What happens if the bond market craters before all of those front-running traders are able to unload all those over-priced bonds? In that case those traders would have a huge loss on their hands.

The Table Is Set For an Epic Collapse

A little bit of math will drive home what’s at stake.

Say that each month the ECB buys $60 billion of bonds from the banks and the speculators. 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 the speculators who bid them up, and who are now sitting on paper profits.

(They’re called “paper profits” because as long as these investors still own the bonds, all gains exist “on paper” only, as mere accounting gains. No profits exist in reality until after those traders actually sell the bonds, and “realize” or “lock in” their gains.)

So while the ECB drops $60 billion a month on bonds whose prices are grossly inflated, all the holders of the remaining trillions of dollars’ worth of bonds have to sit on their bond inventories, hoping and praying nothing goes wrong.

As you’re about to see, a lot can go wrong.

Snowballing Bond Risk Spells Disaster

The first danger is 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 in the U.S.

The bond markets are also threatened by a growing lack of liquidity. 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.

Then there’s the specter of inflation. Sure, there’s none right now. But that can change. Any big uptick in inflation would send a chill throughout the entire bond market, as the prospect of higher future rates would devastate current bond prices.

The “Other” Flash Crash and the “Short of a Lifetime”

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 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%.

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 to hear better economic news and to see yields start rising.

Treasury bonds are traded by every big bank in the world. As you’ve seen, 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.

I’m not the only one who has noticed the peril.

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.”

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 is that I believe we’re looking at a big bond-market collapse. The only part I can’t predict with certainty is the timing. Nobody can do that.

I can give you a strategy to profit, though. And that’s what I’m going to do right now.

My 4-Part “New Greatest Trade” Profit Strategy

When the European bond bubble breaks, you want to be …

1. Short European bonds…

2. Short European stocks…

3. Short the euro against the U.S. dollar.

You’ll also want to be long U.S. Treasuries, as their price will skyrocket in a ‘flight-to-quality’ trade.

Here are four trades to help you do all of this and to make maximum windfall profits when the bond market unravels.

To short European bonds, I recommend you buy “Puts” on the iShares PLC Markit iBoxx Euro High Yield Bond ETF (LON: IHYG).

You won’t find many good, liquid exchange-traded funds (ETFs) that give us the direct exposure we want to short European government bonds. 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.

Editor’s Note: It is possible your broker might not buy IHYG. In that case please read the bonus section at the end of this report (“A Bonus Play on the Collapsing Bond Market”) where Shah has a fallback plan for shorting European bonds.

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

When the bond collapse happens, the EMU’s currency – the euro – will collapse, too. For that reason I recommend you buy 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.

That brings me to the U.S market.

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.

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” combo could very well take the title as “The Greatest Trade Ever.”

A Bonus “Greatest Trade” on the Collapsing Bond Market

For those of you whose brokerages won’t let you short the iShares PLC Markit iBoxx Euro High Yield Bond ETF (LON: IHYG), here’s another way to play falling bond prices across Europe.

If bond prices fall, banks and financial institutions holding them will take a tumble, too.

So, if you want exposure to falling European bond prices, I recommend shorting the iShares Trust iShares MSCI Europe Financials ETF (Nasdaq: EUFN).

My recommendation would be to short EUFN here at $23.25 or higher. You should also consider shorting an equal additional amount at $24.50, more at $25.50 and more at $26.50, which is the ETF’s 52-week high.

If you “average up” on this short, you’d be short at an average price of $25.

I’d cover my shares at $27.50 if the ETF makes a new high there. I’d accept a 10% loss – with a frown, for sure. But a 10% loss is acceptable to me.

Another way to play a drop in this ETF would be to buy the October $21 Puts options. I’d pay 50 cents apiece for them. However, because timing is a lot tougher with options – and because if the puts expire worthless you’ll lose everything you invest in this trade – I’d risk a lot less than what I’d be willing to put down to short the stock.

Of course, if EUFN drops like a stone and ends up below $20 by expiration, the put options will have a much higher return.

You also don’t have to wait until expiration to sell your puts. If you want to cut your loss in the case the trade goes against you, you can sell them at any time. And you can sell them before expiration to potentially make a killing if EUFN drops a lot before expiration.

Have at it!

We’re Going to Profit from History’s Biggest Bond Bubble

At some point, the Federal Reserve is going to raise domestic interest rates. And that move will have observable impacts, because the world is connected both economically and via the global capital markets.

When rates rise in the United States, U.S. investment capital currently planted overseas will add to any foreign investment flows streaming back to American shores to take advantage of those newly-higher interest rates.

The “capital flight” out of countries that need that money will wreak havoc on their markets and economies. To stem the outflow of money seeking higher rates of return, those countries will raise their own interest rates.

How’s that going to work out for all those speculators holding high-priced, negative-yielding bonds?

Not well at all.

Bond prices will fall. Leveraged players will panic and dump bonds. Prices will tank further on the selling frenzy.

Nothing goes up forever. We’re now looking at the biggest bond bubble the world has ever seen.

The only thing that’s not assured is the timing of the explosion.

But now you know how it’s going to end. And you know what to look for.