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The Widow-Maker Trade

04.01.2016

The US labor market is approaching its capacity ceiling at the same time as the global savings surplus is decreasing. The risk of rising government bond yields is undervalued.

Shorting Japanese government bonds has been systematically unprofitable for the past thirty years. This has given the strategy the ominous nickname "the widow-maker trade".

In general it has been a bad idea to short government bonds in all western countries for several decades. Since the early 80s, interest rates have mostly only gone one way.

For the first twenty years the interest rate decline was driven by falling inflation. The fall of the Wall led to a supply-side shock in the global labor market as hundreds of millions of poor workers in China and Eastern Europe were incorporated into the capitalist system.

This helped restrain both wages and prices in the rich part of the world.

Greenspan's conundrum

However, over the past ten years the interest rate decline was mainly caused by falling real interest rates and term premiums on government bonds. The term premium is the excess return that investors get by investing in long term government bonds rather than short term.

The term premiums had already dropped so much in 2006 that Greenspan called it a conundrum. However, it has only declined further since then, and the mystery has only gotten bigger.

The fall of real interest rates and maturity premiums to exceptionally low levels is probably due to an abnormally strong demand for bonds over the last decade.

China and OPEC

First of all, China built up gigantic foreign exchange reserves during this period of which the majority was invested into western government bonds. Major oil-exporting countries also increased their financial saving sharply.

As if this was not enough, after the financial crisis many central banks implemented quantitative easing. This further increased the buying pressure in the bond market.

However, many of these capital flows turn these days. The Chinese foreign exchange reserves fell by 87 billion to 3438 billion dollars in November and a further decline can be expected given the problems in the Chinese economy.

Low oil prices also mean that oil-exporting countries must now draw from their savings.

Rapidly falling savings surplus

A rapidly diminishing savings surplus in the world has created risk of an abrupt increase in both real rates and maturity premiums in 2016. As if this was not enough, the risk of inflation might be underestimated.

The labor market in most OECD countries, with the exception of the eurozone, is nearing its capacity ceiling, and after a number of years with minimal pay increases workers may soon be in a position that enables them to claim their fair share of the profits.

There are already sporadic signs of wage pressures in the United States, including in the restaurant and health industry. Increasing wage growth momentum can lead to powerful tremors in the bond market. The reason is that long-term inflation expectations are currently only 1.5 per cent, which is well below the central bank's target of two percent.

"The widow-maker trade" has wiped out a lot of fortunes over the past thirty years. However, this may change in 2016 due to minimalized real rates, maturity premiums and inflation expectations.

Favorable macroeconomic climate

We start the year by putting Ekornes into the Dovre portfolio. In a world of falling commodity prices, the consumer is the winner. This, as well as a weak NOK, creates a favorable macroeconomic climate for the furniture manufacturer.

Dovre portfolio:

• Panoro Energy

• PGS

• Ganger Rolf

• Selvaag Bolig

• Biotec

• Ekornes

Inn: Ekornes

Out: Det norske oljeselskap