U.S. Treasuries look so lousy here that shorting them has become the “obvious” trade. But there is more to this mystery than meets the eye, as Justice explores...
Jim Grant nailed it in a recent Financial Times piece. Known for their “risk-free return” in more normal times, Grant observes that U.S. Treasuries (or USTs for short) now offer “return-free risk.”
Treasury buyers, in other words, choose to lend to Uncle Sam for free these days... or, worse still, to pay for the privilege. As 2008 draws to a close, USTs are an asset class with no yield to speak of... microscopic upside potential... and plenty of room for a downside break.
“Return-free risk” indeed.
But here is what bugs me. Buying Treasuries is such a plain-as-day dumb move that shorting Treasuries has now become the “obvious” trade.
It seems too easy... I don’t trust it. Sometimes a trade really is that simple. But more often than not, that which appears “obvious” in markets turns out to be a trap.
So what are the missing puzzle pieces here?
Covering Their Assets
The first thing to note is that there are few truly “dumb” buyers out there. Anyone scooping up Treasuries at these nosebleed heights has their reasons.
End-of-year accounting is one factor. A number of money management firms may be parking their dollars in short-term Treasuries as a conservative move. When the final 2008 statements go out, these firms want to present an image of prudence. So they’re willing to take a short-term hit on that parked money for the sake of appearances.
The foreign asset mix is another big factor. Foreign investors were huge buyers of “agency” securities over the years – bonds and notes issued by the likes of Fannie Mae and Freddie Mac.
Now foreign investors are trying to dump those holdings as fast as they can. They no longer trust these “agency securities,” but they have few good places to park the cash. So what are they doing? Swapping out their “agency” debt for the safest stuff they can find in a pinch.
The New York Times chart above tells the story. In a piece titled “Foreign Investors Trade Safe for Safest,” Floyd Norris writes:
More foreign money came into Treasuries in October — almost $91 billion — than in any previous month.
Most of the money — $56 billion in October — has gone into Treasury bills rather than into longer-dated bonds and notes. That flow helped to push down interest rates on bills to historically low levels, sometimes even a bit below zero, as investors sought complete safety.
King Kong Waiting in the Wings
There could be another reason, too, as to why the shorts haven’t piled into USTs yet. That reason is the Fed.
With the Fed Funds target now in a “range” of zero to 0.25%, the Fed has no more ammo on the rate-cutting side. The chamber of that particular sixgun is empty.
But Ben Bernanke isn’t worried about being out of bullets, as you know, because the Fed has so many “alternative measures” available for juicing the economy.
Those alternative measures include buying Treasury bonds.
If the Fed feels the need, in other words, they could buy hundreds of billions worth of USTs at a clip in order to keep interest rates low. The Fed has further expressed willingness to move as far out along the curve as necessary. Two-year, ten-year, thirty-year... all are fair game for a Bernanke buying binge.
The Fed’s bond-buying option is both a promise and a threat. It’s a promise in respect to keeping interest rates low for “a considerable period of time.” It’s a threat to all those investors who want to keep their money hidden in a mattress – or some rough equivalent thereof – rather than putting it back to work in the economy.
“The policy will work if applied with sufficient ruthlessness,” writes Martin Wolf of the Financial Times.
That ruthlessness could include ramming and jamming the bond market like nobody’s business if bond prices fall (and rates conversely rise) to a greater degree than the Fed’s liking.
The Dollar Speaks
If the Fed were indeed to put a huge bid in the treasury market, how would they do it?
The mechanics would no doubt be convoluted. Bernanke would probably dream up a fresh entry for his growing seven-letter acronym collection in order to describe the new bond-buying “facility.”
But, at the end of the day, the smoke-and-mirrors accounting has to come out in the wash somewhere. In this case, a Fed bond-buying binge would put the market awash in a tidal wave of new dollars. (Bernanke would have to put dollars into the hands of the private sellers he is buying bonds from.)
The sinking in of that reality – the Fed’s willingness to prop up bonds with printed dollars – might explain why the U.S. dollar index just saw its biggest six-day decline in history.
According to Bespoke Investment Group, the dollar’s recent eight-percent-plus drop was the largest ever, besting the previous 7.48% record set in September 1985.
Short-Term versus Long-Term
Based on end-of-year accounting factors and a supply-limited window of foreign investor buying, USTs could be a good candidate for a quick, sharp break (much like the dollar’s swift fall) early in the 2009 calendar year.
An aggressive put option trade – near-term firecrackers relatively close to expiry – could be one way to play this. If done right, it’s the kind of trade where you either lose the small amount you invested or make five times your money in a fingersnap.
If I were to make a short-term play like this, I would do it with money I could afford to lose – probably no more than one or two percent of my total trading account. And if the trade paid off, I would take the money and run at the first sign of stabilization (rather than waiting around for the Fed to bid bonds up after the break).
The other way to look at Treasuries is with a decidedly patient, long-term view.
In the medium term, the Fed’s action profile is decidedly bond-positive and dollar-negative: they want interest rates low and exports strong, which favors strong bonds and a weak currency.
In the longer term, though – once the Fed’s near term issues have been resolved – Treasuries could be setting up for a historic multi-year decline... the sort of epic, drawn-out move in which new trend-following fortunes can be made.