The bubble economy has spawned another bubble. This time it’s government bonds. The flight to safety during 2008 has pushed yields to lows never seen before in Federal Reserve records (compiled since 1962). For example, the yield on the one-month bill stands near 0.04%, two-year note near 0.75%, and ten-year note near 2.21%.
Yet, the federal government has taken on spending commitments that entail gargantuan budget deficits for some time and a tsunami in bond issuance. Current spending commitments include trillions of dollars for existing commitments such as Social Security, Medicare, etc. and the Iraq war — as well as trillions more for bailing out the financial system, propping up ailing industrial sectors, and massive fiscal stimulus package promised by the Obama administration.
At the same time, the Federal Reserve is creating credit at rates never seen before. As Northern Trust economist Paul Kasriel noted, the year-over-year increase (to November of 2008) in bank reserves is about ten times the previous high, which occurred in 1934. Deflationary forces are ascendant right now but one wonders for how much longer given the massive stimulus unleashed.
Shorting government bonds would thus appear to be a no brainer as risk appetite responds to signs of an upturn in economic growth and inflation worries arise anew. But what might not be so obvious is the timing of the trade.
Lags in the impact of stimulus measures could mean deflationary news will linger for awhile yet. More importantly, the Federal Reserve has stated it is committed to buying Treasuries to keep interest rates low until the crisis and economy stabilizes. China too will likely be a buyer of U.S. Treasuries as part of its strategy of suppressing the yuan to enhance the competitiveness of its exports.
So watching from the sidelines may be the strategy for now. Ways to short the bond bubble include going long on the ProShares Ultra-Short 20+ Treasury (TBT) and ProShares Ultra-Short 7-10 Year Treasury Fund (PST) ETFs (but understand the constant leverage trap first) and short selling the iShares Lehman 20+ Year Treasure Bond ETF (TLT).