Michael Burry made a name for himself shorting the US housing market in 2007-08, immortalised in the movie, The Big Short. Ever since then, the financial media has paid close attention to Michael Burry’s positions hoping that he will be right in the same way he was back then. Recently, Burry has found another target to short, which the financial media has labelled the ‘Pretty Big Short’. The target of this short? US Treasury Bonds.

The way that bond prices work is that the face value moves inversely to interest rates. As interest rates go up, for example from 1% to 2%, and new bonds are issued at the 2% rate, existing bonds that were paying 1% fall in price so the can be purchased for a 2% yield. So a $100 bond yielding 1%, i.e. $1 interest per year, will fall to $50 so that $1 interest is the equivalent of 2% for the person buying it.

Burry is betting that interest rates will rise and that the price of US Treasury bonds will fall as a result. Earlier this year on Twitter, Burry argued that the economic reopening and government stimulus would create inflation and force the Federal Reserve to raise rates as a result. Now with $280 million in put options on the iShares 20+ Year Treasury Bond ETF, Burry is putting his money where his mouth is and hoping to make money as the face value of the bonds held in this ETF fall.

At Newcastle Advisors we hold a similar view.

With historical low cash rates and the recovery from COVID continuing (in the USA/UK, with the Australian recovery delayed by another 6-12 months after recent restrictions and domestic politics), the noise that rates will begin to increase continues to get louder.

Our principal Advisor Matthew McCabe, remembers in 2007 when his mentor told him to study the 1994 Bond market crash.

“This was a real eye open, as bonds which had been considered a “defensive asset” can lose a significant amount capital as interest rates rise.” McCabe stated.

What happened in 1994

In February 1994, the Federal Reserve's key interest rate was sitting at 3.0%. This was extremely low by historic standards. It had been sitting at that level for 17 months, and the last time anyone had seen rates go up was six years previously.

Does this sound familiar?

That in itself is a pretty useful reminder that, while our current situation is unprecedented in terms of scale, it's not the first time that interest rates have been left sitting at historic lows for a long period of time.

The US economy was perking up and had been growing for nearly three years. So the Fed thought it was about time for interest rates to start rising, to head off any threat of inflation.

Does this sound familiar?

In February 1994, the Fed raised interest rates to 3.25%. It raised them again in March and April, to 3.75%; and then by 0.5% in May and August (so we're at 4.75% now). Then, in November 1994, the Fed actually raised rates by 0.75% in one go. Even before the financial crisis, that would have been a punchy move. So by the year-end the Fed Funds rate stood at 5.5%.

Bond investors hadn't expected the Fed to move as quickly as it did. There was a global bond panic, and yields shot up (which means that prices fell).

According to a paper by the Bank for International Settlements (the BIS, the "central banks' central bank") written in December 1995 the real problem wasn't Fed policy. It was "the internal dynamics of the bond market". In short, bond investors had simply become too complacent.

Bond market volatility was extremely low. Bond investors were betting on interest rates either remaining stable or falling further, and using leverage to do so. When you employ leverage borrowed money you magnify your gains and losses, and vastly increase your chances of being wiped out.

However, many experts believe that 1994 will not be repeated again. That is mainly because the Fed is highly unlikely to raise rates at the pace we saw in 1994.

What are you doing with your superannuation and investments?

As discussed above, are you being complacent?

Do you understand where your monies are invested?

Do you understand what investing in a diversified index fund or ETF actually means when rates rise?

What are our Newcastle Advisors doing?

We are starting to move all our clients to actively managed fixed income investments.

For those that are concerned with higher investment management costs, there are still options available where the investment manager actively managers or has the ability to tilt the asset allocation as they see fit (including moving to shorter duration bonds and floating rate corporate bond investments)

Need expert support?

Speak to your local Newcastle & Lake Macquarie Financial Planning Advisors, who have the experience and expertise to understand the markets and how to make changes to your portfolio to limit or reduce the associated risks with rising interest rates over the next few years.

Apply to become a client

Sources:

https://www.bloomberg.com/news/articles/2021-08-21/michael-burry-s-pretty-big-short-hinges-on-treasuries-sinking?mc_cid=006109af8e&mc_eid=186c3d3c94

https://www.imdb.com/title/tt1596363/

https://www.smh.com.au/business/markets/michael-burry-of-the-big-short-bets-against-one-of-wall-street-s-biggest-stars-20210817-p58jaw.html

https://news.sky.com/story/the-big-short-against-ark-innovation-two-of-americas-most-famous-investors-go-head-to-head-12384578

https://www.wsj.com/articles/big-short-investor-michael-burry-other-hedge-funds-bet-against-cathie-woods-ark-innovation-etf-11629227796

https://www.bloomberg.com/news/articles/2021-08-21/michael-burry-s-pretty-big-short-hinges-on-treasuries-sinking

https://finance.yahoo.com/news/ark-innovation-etf-sell-big-210000360.html

https://moneyweek.com/473408/heres-what-happened-the-last-time-the-bond-market-crashed

The BIG short