Spread is the Word

I thought it was clear the plan was we would share
This feeling just between ourselves
But then the music changed
The plan was rearranged
He went to dance with someone else
--Shannon

Interesting dynamic setting up based on the 'risk off' flight to quality taking place in government bonds. Central bank interest rates near zero have attracted scores of carry traders. Carry traders borrow cheap funds from central banks and invest these levered funds in securities thought to return more than the cost of 'carry.' That cost of carry is currently viewed as next to nothing.

When times are stable this is like free money to those who can get their hands on Fed funds. But times aren't always stable.

Assume for a moment that carry traders invest the bulk of their borrowed funds in sovereigin bonds. Carry traders with average risk profiles are likely to spread their buying around--purchasing some some riskier paper (e.g., Greece) as well as 'risk-free' paper (e.g., US, Germany). The riskier paper earns a wider spread which means that it juices profits.

However, if/when turmoil hits riskier sovereigns, carry traders (except for Mr Corzine's shop) quickly dump the Greek paper and pour into UST's and German bunds in size. Lower spread, yes, but less risk of a negative cost of carry on borrowed funds.

All good, except that flight to quality in the extreme such as what we're seeing now begins to compress spread on even the safest of bonds to such narrow ranges that unexpected changes on either end of the trade (i.e., lower prices of bonds; higher borrowing costs) would tank this trade.

I can't help but wonder when the current move into USTs and bunds winds this trade so tight that any disturbance throws the bond market into turmoil.

Also, is it not obvious that FOMC efforts to signal that short rates will be ultra low for years is meant to appease carry traders--to instill confidence that the Fed will not pull the rug out from underneath this group? "You just keep on borrowing and buying, boyz, we've got your back..."

Without that assurance, debt markets would likely already be in chaos.

position in BOND