The Dollar vs. Treasuries Dichotomy

Let's take a closer look at the behavior of the dollar and Treasuries lately. Here I mused that Treasuries are pointing to a financial panic, whereas the dollar isn't.

On the graph below (click to enlarge), the PowerShares DB US Dollar Index Bullish Fund (UUP), is a proxy for the dollar, compared with the iShares Lehman 20+ Year Treasury Bond (TLT), long-term Treasuries ETF. The Y axis reflects a percentage change of these ETFs since July 1 of this year.



The vertical lines split this chart into 4 periods. As we can see, in the first period, from July 1 until about October 6, both dollar and Treasuries moved up slowly. My idea at the time was that the world was running scared from all asset classes into US Treasuries, buying a lot of dollars along the way. That would be worldwide financial panic.

Then we have the period from October 6 until October 24. Treasuries were moving sideways and a little bit lower, but the dollar was in a parabolic rise. Was it a case of the dollar carry trade unwinding?

Next period, between October 27 and November 17. Both ETFs trade in range.

And then comes the most interesting part, after November 17. The dollar still trades in range, but we have a rapid, insane rise in Treasuries. Coupled with failures to deliver, this amounted to real panic buying.

So what's happening? We can't attribute this to the international buyers, because the dollar is not rising. My best guess is that funds of different kinds (endowment, sovereign, state and company pensions, etc.) are moving into Treasuries from other asset classes. They already lost hundreds of billions (maybe trillions) of dollars on the stock, bond and commodities markets. Looks like now they are investing in the safest paper possible. Trouble is, at these price levels, Treasuries are a lousy investment. You need to hold them for decades to get any kind of return.

Can we make money off this? Doug Kass thinks it's time to short Treasuries, for example here. He is currently short TLT. I don't want to do that, yet. First of all, it's dangerous to short bubbles. Second, failures to deliver probably keep a lid on the prices, which can go even higher. Last, but not least: Treasury prices are at Great Depression levels right now. If we are in GD 2.0, they might remain at high levels for a long time. I will be watching for inflation data. If we start seeing any inflation at all, then it's time to short Treasuries. If we go into a depression, then the time to short will be when this fact is commonly accepted. I'll short when I see the New York Times headline "Great Depression II!".

Full disclosure: at the time of publication author had no positions in UUP, TLT or any other stocks related to Treasuries. Positions can change any time.

Comments

[anarchist:]

You won't see that headline until after January.

2008 Dec 05 12:21 PM

[John Lounsbury:]

Interesting opinion and excellent analysis. I have been referring to the bond bubble (treasuries) of 2008-2009. Your discussion points out that the "bubble" might last for much longer. Good point. However, even if it takes years rather than months to burst the "bubble", it is prudent to keep nibbling at shorting treasuries. After all, interest can't go below zero. (Or can it?)

Over extended periods from 1980 to 2000 stocks and bonds were positively correlated. Since 2001, the historical norm (negative correlation) has occurred some of the time. There has definitely been negative correlation over the past 14 months and this is likely to continue for many months (years?) into the future. Thus, a good trade for the past year and looking forward is shorting stocks and buying bonds, continuing until it's time to buy stocks and short bonds. Timing? Track both stock indexes and treasury prices. They should both give the reversal signal within a few weeks of each other.

2008 Dec 05 12:31 PM

[M dub:]

What we are seeing my friend is FED and/or Treas buying the long end of the curve.

"Hey, we're the government, we can shorten our duration and massively increase our refinancing risk for global depression scenario...why not, if the banks can go bust why can't we join the party?"

Well, its the only trick left in their book and now its gone....

2008 Dec 05 01:29 PM

[dlaw:]

Excellent article asking an excellent question.

Portfolio rebalancing in the wake of the credit disaster is truly breathtaking. Investors would rather go risk-free than earn a risk premium, apparently. In a deflationary secnario, of course, the effective return on Treasuries is much higher, since the money received is more valuable than the money deposited - particularly if you look at the performance of the top 20 world currencies against the dollar.

2008 Dec 05 03:11 PM

[dlaw:]

I think the reason we haven't seen a dollar rise in relation to the demand for Treasuries is the incredible amount of dollar liquidity pumped into the system.

2008 Dec 05 03:12 PM

[DannyBoy29:]

Tons of dollars being pumped into the system and the fed buying longer term T Bills (one of the few options left for them). Treasuries are the next bubble but It's still too early to short them.

2008 Dec 05 04:17 PM

[huangjin:]

People thought stocks were a bubble in 1996...

2008 Dec 05 05:06 PM

[Smarty_Pants:]

Don't forget that even the long end of the debt market is returning a negative real interest rate. Even the "official" gub'mint figures for inflation exceed the yield on the long bond and they are probably understated.

You have to scratch your head when everyone is piling into an investment guaranteed to lose you money over time. Doubly so when they are buying debt from the largest debtor on the planet.

It will have to end eventually, but as several have noted in earlier posts, bubbles can be persistent. Tread carefully.

2008 Dec 06 09:58 PM