How Investors Can Profit from the Coming Bear Market in Bonds

Understanding the bond market can help us understand what is going on from a macroeconomic perspective, and how other financial markets may react. Here are the key points traders should consider:

1. The Fed is looking to lower rates, and appears to be headed towards zero percent. The Financial Ninja has an interesting post on this subject, which I recommend. So the Fed is expanding the monetary base, but as banks have been refusing to lend, the effects have yet to be inflationary. However, should lending resume, the Fed's attempts at expanding the money supply could result in currency devaluation, which would increase the yield that bond buyers demand. As bond prices and bond yields are inversely proportional -- meaning an increase in bond rates will decrease the price of existing bonds issued at a lower rate -- this would result in falling bond prices.

2. Moreover, the US national debt is just getting started. CalculatedRisk tells us that the national debt is now over $10 trillion and rising quickly. But of course, debt, like anything else, does not have infinite demand, and competes with other financial assets for investment dollars. To ensure that demand for debt increases as supply for it does, the rates on government bonds may need to increase. This would send the price of existing bonds down, while sending interest rates up. This would be a very deflationary environment.

3. The other option is that the Federal Reserve simply buys the government debt. This would prove to be immediately inflationary, and would decrease the value of dollar-denominated assets, including outstanding bonds  issued by the US government. This would push bond prices down.

In many ways this is at the heart of the inflation vs. deflation debate, which I've talked about regularly here on SeekingAlpha.

Leading Indicator: Credit Default Swaps

Credit Default Swaps (CDS) can be thought of as an insurance policy that protects debtholders against the default risk of their borrowers. Credit default swaps are currently pricing in an increased of default on US government bonds. Prudent Bear explains:

According to data provided by CMA DataVision, the credit specialists, the 10-year credit default swap spread – a form of insurance contract against issuer default – has risen steadily - from 1.6 basis points (0.016%) in July 2007, to 16 basis points in March 2008, to 30 basis points in September, to over 40 basis points on October 27 – see the chart below for the spread history so far this year.  In other words the cost of insuring against a US government default has risen by 25 times in little over a year. Similar trends have been evident in the UK and German government bond markets.

The more default risk the market expects, the more bond buyers will refuse to buy additional debt or will demand greater interest rates for doing so.

How Can You Trade This?

And so, we can conclude with the most important question: how can you profit?

If you want to trade this scenario, TBT -- the ETF that is twice the inverse of the daily performance of the Lehman Brothers 20+ Year U.S. Treasury index -- is a good option, and has been recommended by esteemed investors like Jim Rogers and Marc Faber. Also worth noting is that the yield 30 year US Treasury bond recently hit a 30 year low, and has been rising since -- this is one indication that the Treasury bond bubble may be bursting. The Daily Reckoning has an insightful article on this subject.

Comments

[doubleguns:]

Simit---Under point # 2 you stated that this would be a very deflationary environment. I am assuming that you ment only for bonds not the general market? Wouldn't the value of the dollar be falling in this environment? If not what do you forsee for the general market when bonds are deflating?

2008 Nov 05 11:27 AM

[John Lounsbury:]

Simit - - -

Once again, my compliments on a well constructed article and argument. For some time I have wanted to do an analysis on a possible treasury bubble, but still haven;t found the time. If you keep going with your work you may finsih that job before I get started.

By the way, I would have liked to have seen the chart referred to in the Prudent Bear quote.

2008 Nov 05 11:32 AM

[John Lounsbury:]

Doubleguns - - -

In an inflationary trend the value of the dollar has a tendancy to devalue because a dollar buys less. In a deflationary trend the value of the dollar has a tendancy to increase in value because a dollar buys more.

2008 Nov 05 11:47 AM

[doubleguns:]

Simit, My straight forward question is when the bond is deflating is every thing else inflating? Sorry I sometimes cant think and type at the same time.

2008 Nov 05 06:28 PM

[Simit Patel:]

Hi doubleguns,

Thanks for your comments. If the Fed raises rates to increase demand for bonds, that will have the effect of tightening the money supply. technically speaking, tightening the money supply is deflation.

i expect, though, that demand for the US dollar will still decline and will do so faster than supply for dollars declines, and thus i would still expect a weaker dollar even if we have monetary deflation. ultimately, though, i am expecting the fed to buy most of the bonds, and thus for most deficit spending to be inflationary as the fed will just print money to buy the bonds.

there are, however, those who believe we will see ongoing deflation and dollar strengthening. the rationale is that the fed will raise rates to increase demand for treasuries, which will increase demand for US dollars and a higher yield will increase investors willingness to hold dollars. so it depends on how you view things. my personal view is that the fed will end up buying most of these bonds which will prove to be inflationary, and that even if the fed tries to raise rates, demand for US dollars will continue to decline, so i am expecting dollar devaluation, and will look for opportunities to trade accordingly (i make entry decisions based on when price movement begins to confirm fundamental economics).

hope that makes sense. :)


On Nov 05 06:28 PM doubleguns wrote:

> Simit, My straight forward question is when the bond is deflating
> is every thing else inflating? Sorry I sometimes cant think and type
> at the same time.

2008 Nov 05 07:06 PM

[doubleguns:]

Thanks Simit, Your thoughts and ideas are very informative.

I can not see the fed doing anything to deflate this economy any more. Inflation is a dragon that can be slain but correcting deflation can be like hearding cats, everything keeps slipping away. I agree with you that inflation is most likely but we are in for some relative short term deflation first. I think you mentioned this in a previous blog and I agree. The longer it stays deflated the longer it will be before the average Joe gets back in. Our baby boomers may get out and stay out.

My biggest concern however is that if the fed doesn't get this deflation slowed or turned around soon we will become cat hearders for a very long time.

Housing doesnt look to turn anytime soon, autos are going quick, loans are returning to previous standards of % down payments or wonderful credit-- probably both soon, derivatives need deflating and that is a bigger problem, OBama needs training, and many of the people that are taking over government hate the previous administration and may do things differently just to make a political statement. Cut off everyones nose to spite everyones face.

There is apparently no recovery plan so the political environment looks bleak. I am not sure if the new administration will push us back from the edge or completly over the edge. The same holds for the present administration. I heard on CNBC a perfect description of the present financial recovery plan as simply financial "wac-o-mole" which does seem to accuratly describe the present plan. Smack anything that pops up. That is probably what will continue since no one has any clue what to expect next. We are in uncharted waters.

2008 Nov 06 09:37 AM

[Rhunzzz:]

Dear Sir,

I agree with your suggestion of the Treasury issuing bonds directly to the Fed in exchange for cash which would then go to finance spending increases and tax cuts. This would be inflationary, which is the whole point in a situation where deflation is a threat, and would create new cash that can be used for stimulus, WITHOUT increasing bond yields.

Still, the end result may be the same - long-term interest rates may have to go up because eventually the inflationary genie must be put back in its bottle, after it has done its work of course.

2008 Nov 08 10:27 AM

[redst8r:]

Thanks to all for the intelligent discussion; especially Doubelguns who asked my exact question and Simit for his answer. I have been struggling to understand how to connect asset deflation with trillion dollar bailouts that should be highly inflationary.

Clearly a short term deflation is ongoing and while problematic it is necessary in order to complete the deleveraging of financial and hard assets. And it is that same deleveraging process that is the link between current deflation and future inflation.

Once the deleveraging is complete and asset valuations are trusted then lending will gradually resume and inflation will rear its ugly head.

Simit: It may be too early to take the TBT trade. IF the current deflationary, deleveraging is derived from the housing bubble then perhaps the bottoming of the housing market (e.g., builders) is the fundamental indicator to establish a time to initiate inflationary trades.

2008 Nov 09 04:44 PM