Last week I published my first article with Seeking Alpha which generated a comment asking about my opinion on the 30 year U.S. Treasury bond. Since I thought it was a good question, I decided I should try and begin to tackle the subject. The short answer to the question is that I refuse to fight the Fed and the Fed is supporting the long bond. In the long run, however, it's toast. Book it. Beat it. Rail against it all you want, but the 30 year U.S. Treasury bond will drop drastically in price.
The big question everyone wants answered is, of course, when?
I'm sorry to report that I have no more a crystal ball on this than the Mayans did about the end of the world. And if I claimed such knowledge I would recommend you stop reading anything else I ever write because I would have given you prima facie evidence that I am an idiot. So, while I may be an idiot, I'm not about to go out and consciously advertise that fact in public. Hence, I don't know when the long bond is going to approach dying, only that it will.
In the meantime, your shorts of the iShares Barclay's 20+ year Treasury Bond ETF (TLT) will continue to lose you money because fighting the Fed is a losing bet.
The QE III Legacy
When the Fed announced QE III back in September and the extension of Operation Twist, it was pointed out then that we were approaching the end of that policy as the Fed owned more than 36% of the 10+ year maturity bonds in existence. Moreover, there was less than $650 billion in 10+ year maturity bonds left in private hands, so how much more could they possibly buy before buying up all the liquidity?
The answer was about another 3 months' worth. Hence, QE 4 and the Fed engaging in more unsterilized QE.
So, if the Fed can't buy anymore of the existing supply then what's next? As Jim Rickards has been pointing out, some of the buying will come from the primary dealers - who will just repo them back to the Fed anyways - but to do that the Fed had to buy up worthless Mortgage Backed Securities (MBS) from them to unclog their portfolios; continuing the practice of polluting its own balance sheet for the sake of its primary dealers, many of whom are 'stockholders' in the Fed itself. The MBS program was put in place first with the announced intention doing so in perpetuity. Once that program was in place then the Fed was free to restart unsterilized QE and Fed balance sheet expansion.
Enter the Samurai
The rest of the buying will come from Japan and the Fed itself - unsterilized QE. During 2012 Japan raised its holdings of U.S. Treasury debt by $76.7 billion (December 2011 to October 2012, latest data). It began buying in earnest last fall to help make up for what the Chinese had liquidated. Japan has been able to get away with this because of the massive buying of JGB's that took place between March and November - see table below. Yields on JGB's up to 10 years dropped sharply along with U.S. Treasuries as the world expected the EU to break up and countries leave the euro etc. Both countries' debt was used as a safe-haven play and not gold, thanks to Basel II rules. None of that happened nor is it going to happen. The Euro project is 60 years in the making, one does not throw that way over a couple hundred billion in worthless Greek bonds.
Given that Japan has and will always come to our aid and the new Liberal Democratic Government's desire to engage in endless stimulus, I would be short the Yen (FXY) in 2013, but not the euro (FXE). The short euro trade is most definitely over. The Yen can and probably will rise back over 90 and likely challenge 95 before this is all over. This week's close on the EURUSD pair above $1.32 confirms last week's breakout above $1.317 and sets the stage for a run to at least $1.35 if not $1.40 in Q1. A bullish close on Monday will be a monthly and quarterly closing price above a key resistance level.
Japan is doing this current buying, however, at much lower yield spreads than it did in the first quarter, i.e. it is getting paid much less to be the Fed's dumpster. The spread between 30 year U.S. and Japanese bonds has been halved this year and with it Japan's profit margin on the trade. The following graph plots the spread between similar maturity JGBs and USTs at the close of the final trading day of the quarter in 2012 - Q4 being on the 12/28 close the latest data at the time of this writing. It's plain to see the rush into USTs that happened in Q2 did not favor Japan. And the buying slowed down because of it while the Yen continued to strengthen, especially across SE Asia where Yen-denominated bond offerings sprung up all across ASEAN and foreign ownership of JGBs hit an all-time high at 9.1% of total debt.
I suspect we will see a lot of buying by the Bank of Japan of any new 10 year issues by the Treasury in the first quarter of 2013 as the spread has pushed back out to 0.91%. But, I also suspect that the BoJ will be buying whatever it is that Washington D.C. tells them to buy. With ZIRP in place for at least another 3 years, anything of shorter maturity is just cash with a born-on date, and not germane to this discussion. The Bank of Japan will at least want to be paid something for their trouble and the spread is all they have. To buy 30 year USTs Japan will likely try to chase spread by selling 10 and 20 year bonds.
Financial Repression is Good for the Fed's Soul
So, to answer the original question, these are some of the reasons why I don't think the 30 year Treasury bond is going to break down in price any time soon. Just watching the violent trading action in the bond market last week when 30 year bond yields attempted to breach 3.0% on 12/17 tells me that someone is coming in to prop up the price and kick it back towards "fair value," whatever that means in these financially repressed "markets." My guess is that's the Bank of Japan.
For big questions like this, I look at monthly charts and wait for trend changing signals before reassessing my opinion. Right now the monthly chart for the 30 year Treasury bond is uninteresting. A monthly close above 3.022% I would consider a breakout as there is a very definite line having been drawn across the market, currently a triple top has formed on the monthly chart.
The above chart is a picture of what financial repression looks like in a market that has awful fundamentals, like the U.S. bond market. In no way do I think this is healthy, sustainable or even sane, but it is reality and my opinion on what is the right thing to do is irrelevant to the question at hand.
This is what the Fed is doing.
It is buying $85 billion per month which amounts to a $1 trillion expansion of its balance sheet in 2013 -- roughly the size of the U.S. budget deficit, plus or minus a couple hundred billion. So, the Fed has done its part. As far as the fiscal cliff is concerned I really don't think it is an issue. The old tax rates go into effect. Fine. But, no one is actually going to pay them until 2014, so there is plenty of time for the miscreants on the Hill to figure out a way to steal more of our money, cover themselves and buy as many votes as possible in the process. We've seen retroactive legislation passed previously and we will see it again. Of this I have little doubt. I'm not a big fan of GDP as a statistic so slowing down government spending while they bicker is just fine with me. It means pain now for gain later and a lot less looting of the productive class of society.
The Fed is trying to have its cake and eat it too. It wants inflation but it doesn't want to allow the effects of inflation to show up in the markets it can control. This is part of its psychological game plan to get money flowing and keep confidence high. By controlling prices in the bond markets, in which it is one of the few players left, it can- in the short term- control the major inflation-hedging assets: gold, oil, TIPS. This manipulation has certainly spooked the Gold (GLD) community. But to them I say that the fundamentals in gold have not changed and to continue buying at what amounts to bargain prices. The Chinese certainly are. Ignore the spin in the Bloomberg article.
At these prices I would believe a slowdown in Chinese gold-imports month-to-month has more to do with there being no supply of physical metal out there than a fulfilled appetite. Go look at the futures curve if you doubt me. Gold and Silver both slipped into backwardation last week and the forward months are essentially flat out 3 months. This is not a picture of slack demand in those markets.
Sometimes things are as simple as 'buy the under-valued asset and sell the over-valued one' and the 30 year U.S. Treasury Bond is as over-valued as an asset can get. Trade it if you want, but I think it's suicide. the Fed already steals enough of our money, why would you give it to them willingly?
Additional disclosure: I own physical gold and silver