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We all know what bubbles look like, particularly after they burst. But how do we judge a bubble before it is obviously over? Many have speculated that the time is close, if not already here, to short treasuries.
For some interesting background, let’s look at some recent bubbles. They all have a price curve that looks like a rocket launcher, becoming ever steep, sometimes seemingly approaching vertical. When the bubbles burst, the price curve looks something like the trajectory of a dropping bomb.
The first bubble selected is commodities, represented by i-Shares North American Natural Resources (IGE), shown in the following graph.
This bubble developed over a six year time span, with about nine months consolidation period about 2/3 of the way through (mid-2005 into early 2006). This consolidation came near the 50% point in the price appreciation. When a bubble grows for this long a period of time, some start to proclaim it is not a bubble, but a long term trend. The sign that should disabuse that feeling is the ever steepening rate of price appreciation approaching the top. Once over the top the rocket turns into something with a similar shape, a destructive bomb.
Not all commodities in the commodities bubble conformed to the IGE price pattern. Oil is an example, shown in the following graph.
This bubble grew over a much shorter period of time than commodities in general, taking only about two years to inflate. Curiously, it had about the same three-fold rise as commodities in general, but had much steeper price appreciation, becoming much more vertical near the top. However, as we will see later in this article, this was not the most nearly vertical of the recent bubble tops. Note: There was also a consolidation period of about six months in this chart in 2007, after about 2/3 of the time and half of the price appreciation.
The next bubble to look at is the housing bubble. This is the longest lasting of the recent bubbles, starting about 1997, when home prices embarked on their historic climb. The rise in home prices was by far the smoothest of the bubbles we will review here. There was no period of consolidation in the eleven years the bubble was expanding, just a long period of steady price advances, much above historic average appreciation rates.
The other difference for housing is that, so far the price decline has been less precipitous than the other bubbles have experienced. The nature of both the advance and decline “orderliness” is most probably a result of the nature of the transaction involved. Buying a house is a more substantial financial investment, with a much longer time horizon, than the purchase of a 1000 barrels of oil, a commodity trade in general, a stock, or a bond.
The most famous bubble of the past ten years occurred in the NASDAQ market when the dot.com bubble burst. This bubble took about six years to build, showed the familiar consolidation about 2/3 of the way through (1998) and was nearly vertical for the last year. This bubble, like the oil bubble collapsed all the way to pre-bubble prices. The NASDAQ bubble deflation had more of a struggle early on than the other bubbles reviewed so far; it attempted a rally in late 2000, after a drop of 20% from the top. I know many people who took the bait of that sucker rally and regretted it within months.
As mentioned above, this bubble also experienced a consolidation 2/3 of the way through the time span, but at significantly lower levels of the appreciation range (about ¼). Like the other bubbles, this was about 100% appreciation above the start of the bubble. This bubble just went higher (500% gain) than did the previous examples (about 300% gain).
This brings us to the final bubble candidate: U.S. treasuries, shown in the following chart.
We see here the familiar bubble pattern. This pattern rivals the NASDAQ chart for verticality. It has a major consolidation period early the price advance but more than half way to the present on the time scale. There was also a hesitation in late November, but this was too brief to be considered an actual consolidation.
There is a question mark on the graph. We do not know as yet whether this is another hesitation, as we saw in November, with a quick resumption of the climb, the start of a consolidation period, or the start of a bubble deflation.
The 20-year treasury closed Friday, Jan.2, with a yield of 3.22%. If the yield drops to 2.5%, TLT will advance further to about 155. If the rate rises to 4.0%, the price for TLT will drop to about 98. At very low interest rates, changes of less than 1% in the long end of the yield curve can give very large changes to bond prices.
So how can you sell short treasuries? There are several ETFs that can be used. If you have an account that allows short selling, you can sell short treasury bond ETFs such as:
- (TLT) iShares Lehman 20+ Year Treasury Bond Fund
- (IEF) iShares Lehman 7-10 Year Treasury Bond Fund
- (IEI) iShares Lehman 3-7 Year Treasury Bond Fund
If you can’t sell short in your account, you can buy one of the two new ETFs that take positions short treasuries. These two funds are ultra short funds, designed to try to track two times the daily movement in their target bond groups. While they are generally fairly successful in tracking daily changes, small errors can accumulate and compounding fluctuations can differ under different price movements, so the gains or losses can differ noticeably from twice the bond price movements over periods of many weeks or months. The short sell treasury EFTs are:
- (TBT) ProShares Ultra Short Lehman 20+ Year Treasury Bond Fund
- (PST) ProShares Ultra Short Lehman 7-10 Year Treasury Bond Fund
As mentioned previously in this article, there can be large price changes in bonds for fairly small interest rate changes when rates get very low, as they are now. So investing in these treasury ETFs today is not your grandfather’s bond investing. The funds can boost your returns or blast them (in the wrong direstion).
Disclosure: I have had positions in TBT for nearly two months. The average loss to date is approximately 30%.
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This article has 30 comments:
Just a point. today has turned into more than a typical bubble bust - but a full blown recession. the question is the timing for the snap backs, not the fact that the prices are too low (such as oil, natural resources, or nasdaq). i am betting on one more bottom searching event for the market before we start going back up - but i do admit there is an equal chance of a rally right now.
Yes?
Blond Molly
The devil is in the details. Go to the U.S. Treasury web site:
treasury.gov/offices/d...
There you will find data for Dec. 29, 30 and 31 (the only three days TBT has traded at 36 or below). Your timing, based on what has happened to this point, to buy TBT at 36, was inspired.
The U.S. treasury web site will show you that the following were the yields on Jan. 2, 2009: 10-year, 2.46%; 20-year, 3.22%; 30-year, 2.83%.
Yes, sleepless, the treasury yield curve is inverted on the long end and has been for some time, weeks I think, but have not checked all the history.
Other data from the web site:
10-year - 2.13%, Dec 29; 2.11%, Dec 30; 2.25%, Dec 31; 2.46%, Jan 2.
20-year - 2.94%, Dec 29; 2.88%, Dec 30; 3.05%, Dec 31; 3.22%, Jan 2
30-year - 2.63%, Dec 29; 2.58%, Dec 30; 2.69%, Dec 31; 2.83%, Jan 2
I don't blame you for being skeptical, because the numbers are not what one would assume without having done the research.
The devilish details that have me down 30% are timing details, which, so far, you have mastered much better than me. I am not down 30% because I don't do the research.
You are right, bonds and stocks have been decoupled for some time now and probably will stay that way until we have a more orderly economy. The question of how to allocate a portfolio between shorting bonds and going long stocks is complicated, especially with regard to timing.
If we move out of the current deflationary period into high inflation, shorting bonds will probably give much higher returns than stocks, because the Fed will be cranking up interest rates and stocks don't do as well when interest rates are rising sharply. Initially, though, stocks could have a substantial rise off a bottom, particularly if the eventual bottom is not the one we currently have (Nov. 20), but something sharply lower later this year.
As a previous commenter stated (dakyne), the devil is in the details.
One final thought. What to short in the bond universe is not a trivial detail. If the Fed raises interest rates to a point that the entire yield curve inverts, shorting short-term bonds can give a better return than shorting 20 and 30 year bonds.
I agree, there are lots of opportunities out there, but when to grab each is occupying a lot of my time these days. It sounds like you are grappling with the same beasts.
This is a great article John, and like anything theres risk involved, but like I stated in a recent post on my site:
"I just got into TBT, because Treasury prices are at record prices. When you watch treasury tickers they usually show the yield, which is at record lows. When you buy a bond for 110 with a face value of 100 that yields 5% interest, you are paying a premium of $10 on it and therefore are receiving a lower interest yield, which could be something like 4% (I’m not calculating this this is just an example). So if you look at the price of treasury bonds right now you’ll see that they are at record highs and yields are at record lows.
The TBT play is also based on the amount of debt and leveraging that the government has. If they have to issue more and more debt, and the demand stays the same, then the price will go down, and the yield will go up. I see this as a very likely scenario, considering recent amounts of debt the government has taken upon itself. Therefore I feel very safe with the short treasury play. "
Keep up the good work John.
Regardless, a great inflation hedge to buy the TBT!
Thanks for sharing your work with us.
EDV is also a good short candidate. It has more interest rate sensitivity than TLT because EDV contains 20-30 year STRIPS, which have the same structure as zero coupon bonds (no current interest paid). An example of the greater interest rate sensitivity was shown Friday (Jan. 2, 2009): TLT lost 2.5% while ADV lost 6.7%.
I purchased TBT on 12-23 at $36.557 and immediately sold Mar. 09 covered calls at $38 for $4.00, making my net investment $32.557. TBT is now at $39. If I am called away in Mar. I will make $1.44 on share price plus $4 option premium, or $5.44 on an investment of $32.557 in three months or an annualized return of about 64%, counting commisions. If TBT is under $38 on Mar., I will sell more coverted calls. If TBT is below $32.557 on Mar., I will have made a poor investment.
It doesn't seem likely that the Fed will raise short-term rates any time soon. In fact, their statement with the latest cut to 0-0.25% specifically said they intend to keep rates down for a considerable time. Being in TBT, I'm more concerned about whether (and how much) they might buy long treasuries to keep those rates down. However, I don't think rates can stay this low indefinitely.
On Jan 04 11:09 AM John Lounsbury wrote:
> One final thought. What to short in the bond universe is not a trivial
> detail. If the Fed raises interest rates to a point that the entire
> yield curve inverts, shorting short-term bonds can give a better
> return than shorting 20 and 30 year bonds.
On Jan 04 02:53 PM henarl wrote:
> An excellent article by one of the most astute contributors to SA.
>
> I purchased TBT on 12-23 at $36.557 and immediately sold Mar. 09
> covered calls at $38 for $4.00, making my net investment $32.557.
> TBT is now at $39. If I am called away in Mar. I will make $1.44
> on share price plus $4 option premium, or $5.44 on an investment
> of $32.557 in three months or an annualized return of about 64%,
> counting commisions. If TBT is under $38 on Mar., I will sell more
> coverted calls. If TBT is below $32.557 on Mar., I will have made
> a poor investment.
On Jan 04 02:53 PM henarl wrote:
> An excellent article by one of the most astute contributors to SA...
Shorting treasuries is indeed speculation, as was buying treasuries last summer. If you define speculation as not having a guaranteed return of principle, then there are very few investments available. Two I can think of are holding government securities to maturity and certificates of deposit. You may add something else, but that is all that comes to mind at the moment. Everything else is speculation.
Rather than short the treasury bond (which I do believe will work) a better bet may be to buy the S&P 500 double ETF, symbol SSO. If this monetization occurs, the huge dollar increase will find its way into financial assets quickly. Even if the treasury bond prices slide as the author suggests, the money will seek higher yields and will at some point work its way into good quality stocks.
On Jan 04 08:40 PM Terry Huebert wrote:
> Haven't the Chinese, Japanese and other big buyers made some nice
> gains in US treasuries this year? Won't they keep buying, thus propping
> up prices?
When will the treasury bubble burst? Given the fact that the FEd is starting to buy agency debt and agency MBS in its effort to drive down long term mortgage interest rate, the treasury bubble may be kept going until the FEd cannot keep expanding its own balance sheet, or the triple A treasury rating is doubted by foreigh buyers, or a dislocation occurred in the currency market, then the treasury bubble burst in such a way that will awe and shock helicopter B.
I give it another 6 months.
I think that Roubini and others at RGE have said (check me on this) that the dollar will probably continue to rise vs. all but the yen during the first half of 2009 due to forced repatriation of dollars via deleveraging. That implies he does not think that the market is going up in that interval, right?
Where will this money go, if not treasuries?
Conversely, at the point that these flows diminish, one would think that treasury yields would have to rise to attract further foreign investment. However, at just that point, the dollar might begin to fall vs. other currencies, because the forced repatriation from deleveraging would be diminishing. This could indeed cause a cycle of extreme treasury interest rate increases, as foreign money would be even more difficult to find with the dollar tanking, and yet the need for such money to finance huge deficits from stimulus (and continuing trade deficits) would be increasing.
So, I do believe that treasuries are a bubble that will eventually collapse. But it occurs to me that the dollar may decline just as treasury values are tanking, and since funds that short treasuries such as TBT are in the dollar, you'd end up earning dollars just as the dollar was going down vs. other currencies. In other words, going short treasuries requires continuing to own the dollar, which may tank at the same time that treasuries do.
So, perhaps a better idea would be to go into the Euro at the point that deleveraging flows cease to support the dollar? It could be down pretty low by then - some think as low as $1.10.
If this is correct, then it comes down to a quantitative analysis regarding the extent of treasury decline vs. the extent of dollar decline. I am certainly not prepared to even speculate regarding such quantitative tradeoffs. But can anyone see a scenario in which treasury interest rates must rise but the dollar does not tank vs. other currencies?
Well, that's the general notion. Any thoughts?
It may be that there are so many ways to stack the deck and fix the game domestically if you are the Fed that the only point at which reality will eventually come to bear (no pun intended) is in foreign exchange.
Very good discussion of some of the conundrums with treasuries. Vaughn has outlined one eventual outcome of an extended Fed effort to monetize the debt. If that scenario plays out, then the answer to the title question is no at this time, but sometime in the future will be YES, YES, YES. The eventual hyper-inflation could produce treasury interest rates even higher than when Paul Volker broke the back of the last inflationary surge in the late 1970's and early 80's.
This is not your grandfather's bond market.
There is often a problem for stocks when interest rates rise rapidly. I would suggest that shorting bonds is likely to be making money before stocks advance strongly. When interest rates top out, stocks may make a better move, and as interest rates come back down stocks should do very well.
An alternative scenario is that interest rates stabilize (or consolidate) at current levels, the health of the economy appears to improve and inflation remains tame. In that case, stocks would go up before bonds drop. I am thinking this scenario has a low probability.
Recently stocks and bonds have been decoupled. However, there are times when they are correlated, for example, most of the 1980's and 90's. The two were also coupled, to some extent, as stocks and bonds both dropped for a time under Volker.
The details are in the timing. But I am repeating my earlier comments.
Shorting the long treasury here and going long SSO should IMO be a correlated trade. I agree stocks are hindered by rising rates but I see the spread between treasuries and corporates continuing to narrow with corporate rates falling and treasuries rising. Frankly I am long SSO and TBT. I am just wondering which will outperform, say over six months.
Lots of guys posting around here believe we will break the Nov lows soon. Sorry, but I can't swallow it. I think the lows are in. If I am wrong, TBT will sink along with SSO.
I do not want to fight the Fed. They are adamant that they are going to reflate. To do so they need mortgage rates lower to help put a floor in the housing market. A slightly higher treasury rate won't hurt but a real rise, say back over 5% would hike mtg rates too and interfere with their plans. So I think they will be buyers into weakness, limiting the rate increases until the economy is solidly back on its feet (second half of the year at the earliest IMO). As corporate rates continue to fall, money starved for yield will flow into higher yielding equities lifting stock averages - not wildly but say 20% or so. Maybe slightly more if we are fortunate. The double S&P should rise twice that , or 40%.
I think it will be more difficult to get 40% from TBT if the Fed is working against you. However it should be a profitable trade. Heck, it may be a great long term investment should this prove to be a secular low for treasury rates!
Love your articles. Keep 'em comin' !