Treasuries Will Disappoint- Continued

In a recent post about “bubbly” Treasuries, we got some comments that deserve attention.

First, this is briefly what we said;

“Treasuries have reached bubbly levels, both in terms of low yield and the rate of change of price.

Interest rates will rise when the economy recovers, or when bond buyers demand more long-term interest to absorb trillions of new issues to fund recovery programs. Rising interest rates mean Treasury prices will fall.

… For investors who invest only “long”, closing long positions in long-dated Treasuries, or being alert to a trend reversal necessitating the closing of those positions is recommended.

… For investors who also invest “short”, being alert to a trend reversal creating a shorting opportunity is recommended. The current trend is strongly upward, but could reverse dramatically …”

Some commenters agreed and some did not.

A supportive comment was;

“The safe haven play into Treasuries is demonstrating a true example of a parabolic move. Parabolic moves are unsustainable.”

This amalgam of questioning or counter arguments from commenters is worthy of discussion:

1. There is not yet technical confirmation of a trend reversal
2. Shorting now could result in big losses
3. Treasuries are a safe haven play that may persist for a long time
4. The Fed may put a bid under the long bond to keep rates low
5. The Fed said we face “low interest rates for some time”

We have these thoughts about those concerns:

1) We agree there is no technical confirmation of a trend reversal, but sudden parabolic rises may be followed by sudden parabolic declines. The risk of losses from here due to sudden drops in price (because of diminished fear), even with trailing stops, may be greater than the potential for gain from rates possibly falling further. The easy money has been made in Treasuries.

2) We agree that shorting long Treasuries now is not justified on a technical basis at this time, although it may be justifiable from a fundamental basis before it is justifiable technically. Our recommendation was and is for short players to be on close alert to a shorting opportunity which may materialize soon — not to short yet — the technicals are still positive, but the fundamentals may be negative — we prefer to be in a position long or short when the technical and fundamental logic is in accord.

3) The safe haven aspect of Treasuries is becoming less certain in the credit default swap markets, which recently had increased the price of default protection for Treasuries by 100 fold. At some point, questions about the ability of the US to shoulder its newly magnified financial burden, and the prospect of long-term inflation, may cause Treasury buyers to demand higher rates (prices to fall). If rates stay low and at about the same level for a long-time, the recent capital gain aspect of Treasuries will vanish, leaving only an unsatisfactory long-term interest yield.

4) Without completely debasing the currency (which would create high inflation) the Fed cannot buy the bonds needed to be issued by the Treasury. To make economic sense, new Treasury issuance must be purchased with existing currency held by other countries and other investors, not with IOU’s from the Fed. The Fed buying from the Treasury, if more than transitory, is an economic illusion.

5) The Fed only controls very short-term inter-bank lending rates. The markets set all other rates (unless, of course, legislation sets rate limits — what a disaster that would be).

Asset Allocation Implications

For those who do tactical allocation with periodic rebalancing, this is probably a better time than later to lighten up on long-term Treasuries, moving either to shorter maturities to reduce sensitivity to long-term rate changes, or to lower credit quality for higher yield.

As general adherents to the reversion to the mean principle, and having mistakenly ridden bubbles to the top and then back down in prior experience, we are conservative enough to take some profit now and reallocate to other less bubbly opportunities.

Technical View

The long bond is still in an upward trend, but it is getting tired. That is why we recommend closing positions for those who prefer to take the great middle out of trends without stretching to attempt to catch the very tops and bottoms; or being alert to a possible near-term reversal for those those who prefer to catch as much of a trend after a reversal as possible. Different strokes for different folks.

30-Year T-Bond Daily for 6 Months with Some Indicators

TLT (ETF long 20+Year Treasuries)

TBT (ETF 2X short 20+ Year Treasuries)

A Look at the Pundits’ Views:

In an unusual market, economic and government intervention situation such as we have, opinions are quite diverse and clearly divided on many issues.

Dec. 25 (International Herald Tribune) – The U.S. government bond market, which towers above other assets as the only bastion of strong returns this year, could crumble in 2009.

Bloomberg published a general “bubble” statement in a recent lead paragraph;

Dec. 22 (Bloomberg) — The world’s biggest bond investors can’t stop buying Treasuries even though they’re comparing government debt to Internet stocks just before the technology bubble burst.

Let’s look at what some (not all) institutional managers have to say about Treasuries:

Dec. 11 (Bloomberg) — “Treasuries have some bubble characteristics, certainly the Treasury bill does,” said Bill Gross, co-chief investment officer of [PIMCO], which oversees the world’s largest bond fund. “A Treasury bill at zero percent is overvalued. Who could argue with that in terms of the return relative to the risk?” …

David Rosenberg, the chief North American economist at New York-based Merrill Lynch, said last week that demand for Treasuries had reached the “bubble” phase like in technology stocks in 2000 and real estate six years later. …

Another article the same day said;

Dec. 11 (Bloomberg) — The rally in Treasuries that pushed yields on bills below zero percent this week is adding to concerns that the $5.3 trillion market for government debt is a bubble waiting to burst. …

“At some point we are going to get some signal, some indication that this massive policy response is getting some traction,” said Mitchell Stapley, who oversees $22 billion as chief fixed-income officer for Grand Rapids, Michigan-based Fifth Third Asset Management. “The flight out of Treasuries is something that will be breathtaking.”

How long can non-existent returns be acceptable to investors? Not that long, we would think.

Last week, Jim Rogers said in a 2009 outlook video at Bloomberg;

“[the long bond] is the last bubble left .. it is clearly a bubble”.

Jim Grant was quoted on in Bloomberg for his December 17 statement:

Government plans to sell $2 trillion of debt … are setting investors up for losses, said James Grant, editor and founder of … Grant’s Interest Rate Observer. … ‘What it speaks to is the illusion that some securities are inherently safe or inherently valuable. … People are piling into Treasuries now … I don’t know what they’re priced for, but they’re not priced for life as I know it in this economy.’

Others, however, see Treasuries differently and more favorably:

Dec. 25 (International Herald Tribune) – “Either we get deflation or not,” said Jay Mueller, a senior portfolio manager with Wells Capital Management in Milwaukee. “If we get meaningful deflation, Treasuries will still be the place to be. [but] … if we don’t get the deflation, that will make current Treasury yields look unrealistic and you will do a lot better” in corporate bonds. Mueller put the odds of the U.S. economy skirting sustained deflation at about 60 percent.

Dec. 22 (Bloomberg) – “There’s probably a little more room for the Treasury market to run,” said Thomas Girard, a money manager who helps oversee $110 billion in fixed-income assets at New York Life Investment Management in New York. “We’ve been very, very gently trying to add some non-Treasury-related holdings into the portfolio, but that’s been a very slow process simply because of the powerful rally in Treasuries.”

… Van Hoisington, president of Hoisington Management, which oversees $4.5 billion, said there is no bubble and that long-term Treasury yields have room to fall. … At a yield of 2.56 percent, a rally to 2 percent in the next 12 months would produce a 13 percent return. …“If you accept the fact the economy’s going to be slow-growing for the next three or four years and inflation in fact is going to zero then it would be a bargain,” Hoisington said.

Long-Bond Prices and Rates As of December 24th:

The bond price plotted in black is shown on the right scale. The bond yield plotted in red is shown on the left scale.

30-Year T-Bond, Monthly for 19 Years from 1990

30-Year T-Bond, Weekly for 1 Year

30-Year T-Bond, Daily for 3 Months

Most relevant ETFs are TLT (long 20+ year Treasuries) and TBT (2X short 20+ year Treasuries). Futures can be used to directly target the 30-year bond.

Comments

[CLH:]

A good article giving both sides of the bond debate. However I disagree with the conclusion. It seems to me that this will last many years with very low interest rates and no inflation. Bonds will be the best investment for a long time.

2008 Dec 28 10:14 AM

[BarryD:]

Great article

2008 Dec 28 10:14 AM

[searcher:]

With so many equity vehicles offering yields that will not likely fall enough to make them unattractive, even with diminished revenue and earnings, bonds are not the place to be.

2008 Dec 28 10:48 AM

[dwfm20:]

Really good article, presents the case for both sides. It's nice to pick up some rational discussion of an issue. Once again we are the inflation/deflation crossroads, and need to pick sides on that discussion to have a strong case to invest. My thought is that it is a moving target, and I would rather adjust my strategy to what actually happens and miss the bottom or top of the curve rather than atttempt to predict inflation/deflation.

2008 Dec 28 01:15 PM

[San_Fran_Sam:]

I would just add that there is no reason to take an all or nothing approach to shorting LT Treasuries. The article mentions one vehicle that i am keeping an eye on, namely, TBT. There is also an ETF that is ultrashort the medium term Treasuries, PST.

I have a small position in TBT, about 25% of what i plan to invest, read speculate, in. When it becomes more clear that the bubble is bursting i will add to the position.

During the summer i went both short and long oil because i wasn't sure how when the bubble would burst. I lost a little on the long, but more than made up for it on the short.

2008 Dec 28 02:54 PM

[silverwood:]

The new administration coming to power shortly should be a catalyst, at least resulting in a correction in $USB. It does not necessarily have to be severe. Some profits should be taken at this point in time and TBT is looking to be at an attractive entery point.

2008 Dec 28 08:41 PM

[Moon Kil Woong:]

Actually all market participants are spectators. What matters is the tone and direction the new administration sets for economic policy. The author has it right, Bush Jr.'s team hasn't taken the US on a path that can't be reversed (not for lack of trying). There is great arguments for unrestrained government spending and the fed printing too much money. Likewise as Steve Hansen (the hand) and I have argued the Fed has also been pushing on the brakes with few realizing a 0% interest rate policy is actually deflationary as is the Fed paying interest on deposits.

Certainly, if the US government keeps running up bigger and bigger debts on stimulus plans then we are looking at inflation later. Does this mean there is a bubble now? I would not call it a bubble per say. Bubble tends to mean an asset class has been allocated an unjustified amount of capital and is over speculated.

I would not call people running for safety speculation. On the contrary I would call it the exact opposite. However, it is possible too many assets have been moved to treasuries. Likewise too much is staying parked at banks and in the Fed's account. Strangely, this only increases the pull towards deflation making it a kind of self-fulfilling prophecy.

What may be a bubble is the net amount of dollars the US government is making by constant spending. This eventually makes not just a bubble in Treasuries but also in US dollars. Why do I make a distinction about this bubble aspect? Because in essence the US government is gambling and has been for some time. The bet is that the economy will constantly expand enough to constantly pay for the rising debt and cost of administering the debt. And like all addictions (yes gambling is often an addiction) the Federal Government has been unable to quit and is growing ever more tolerant. Thus it takes more and more capital to keep the ball rolling along.

You know things are going out of control when the deficit gets to be a larger and larger percentage of GDP. The government can solve paying a larger percent of GDP to make the debt payments by deflating and lowering interest payers but at the cost of making the deficit a even bigger percentage of GDP than it already is. Like pneumonia, you can take cough medicine as a temporary reprieve but eventually you will need to take real medicine (antibiotics) sometime.

2008 Dec 29 01:39 AM

[Medici:]

If the bubble bursts, there will be what seems to be a large rush of shorts , so when and if the burst occurs a violent move will be a self-fulfilling prophecy. The short side will become a short term "trend" as treasuries being a bubble is commonly spoke of on CNBC, Bloomberg and Blog after Blog.
Great Post(s) by Mr. Shaw

2008 Dec 29 08:57 AM

[thatguy57z:]

this will give you some in site how it is going to start working. and how they've all ready have it moving foreword go to.
www.youtube.com/watch?.... copy and paste to your web browser , or click on my website

2008 Dec 29 11:47 PM

[Timmothy Posey:]

Another play indirectly from the Treasury bubble is equities, specifically the S&P (SPY) itself. Once the bubble bursts, all that money has to go somewhere.

I suspect the slightest hint of good economic news will convince people to take on more risk. When this happens, I expect a 1500-2000 point rally on the Dow in one day, along with major drops in the 30-yr price correspondingly. This will be the sign that deflation was conquered, the Treasury bond bubble has burst, and we now should worry about higher rates and inflation.

Jan 03 02:42 AM