In our October 25th blog “Whipsawed”, I made mention of my affinity for intersections of logging terms and financial terms. Here’s another logging term with another use: the “widow-maker”. In my experience growing up in the Pacific Northwest, a widow-maker refers to a large broken branch precariously held aloft by nearby tree-branches. So, under the right conditions (like a wind storm, or logging), the detached limb can unexpectedly fall on anyone unlucky enough to be nearby.
In financial parlance, a widow-maker is a high risk trade with great loss potential. More specifically, the term seems to have been co-opted to refer to a particular set of trades common over the past 5 years or so: shorting Japanese government debt and using the proceeds to buying long US treasuries. There are two basic ways this trade could make money – Japan’s bond prices could tank relative to US bonds (and given Japan’s debt burden, that’s a popular notion). However, even if the relative prices of US bonds and Japanese bonds just stay the same, the higher yielding US bonds should pay for the transaction costs. Studious readers of our blog and monthly articles will recognize this sort of strategy as a “carry trade”. The worst case scenario is Japanese bonds holding up while US bond prices suffer.
To be fair, a widow-maker is a term sufficiently generic enough to apply in a variety of venues. For instance, cardiologists use the term “widow-maker” for a particularly strong type of heart-attack, according to some minimal research on my part. Still, the basic rule for using the term is this: high consequences with little potential warning for impeding danger.
Readers familiar with the rules for a successful carry-trade may remember that the strategy depends on stability of international fixed income markets and interest rates to work. Stability is something we just lost. Long bonds have had a huge sell off in the weeks following the election. For example, the 10 year bond yield jumped from 1.776% to 2.478% yesterday – a 27 month high. As a reminder, when bond yields climb, bond prices fall. Moreover, the increase of rates has a multiplicative effect on these high maturity bonds; this is the very definition of high duration – high bond price to changes in rates. Remember all those carry traders who were owners of US treasuries, counting on modest yields or stable US bond prices? They are about to get hit with significant losses on a fixed income trading strategy. That’s the widow-maker trade.