Is the Long Bond Cracking?

We have been saying recently that long-term US Treasury bonds looked toppy (see Dec 25, 2008). Long-bond funds gapped up, which is often an invitation to fill the gap later in a downward movement. T-bonds reached very low rates (as short-term Treasuries approached zero). After the gap up, the long-bond and related funds began to move sideways, and today declined a bit. The T-bond yield charts (inverse to the price charts) show rates moving up somewhat from very low levels.

Related funds such as TLT (long) responded accordingly.

The inverse of TLT, which is TBT, created a mirror image.

If you believe that we have sustained and deep deflation ahead, the long-bond dip may be a buying opportunity. If you believe that we have long-term inflation ahead after a deflationary dip, this may be a shorting opportunity. If you are thinking of trading, then it would be best for you if your view of the technical factors is aligned with your view of the fundamental factors. It’s always best to have major technical trends and fundamental forces pushing in the same direction. A rear-view look at Treasury rates tends to suggest higher rates are ahead. Really, whenever a price of anything is historically high or historically low, it tend to come back toward the middle.

click images to enlarge

Because the current situation is a reversal question, you need to be careful and confident in your reasoning, or your fingers could be burned. One day does not make a market trend for stocks or bonds, but it does appear for now that fear on the equity side is reducing from peak levels according to a lower VIX. Reduced fear of stocks is a negative for low yield Treasuries.

Given the divided opinions of experts with extreme variations in views, and the surplus of bifurcated predictions from single sources with abnormally high upside and downside ranges, all we really have as a truth sayer at the moment is the price action itself. Current market condition assessments are half-empty or half-full. Future projections by noted experts and investment personalities are depressingly negative or ebulliently positive. Note that T-bonds can crash. They have done so before, as this 10 year monthly futures chart shows:

This short-term daily futures chart tells the same story as the yield and fund charts above.

Unlike voiced and written opinions, prices are verified facts. Prices of futures and options are opinions backed by people taking risks with their cash. That doesn’t make them right, but it does make them worth watching. The options prices on TLT (the long-term Treasuries ETF) clearly suggest a drop in the price of Treasuries (a rise in the rates), because the price (adjusted for in-the-money and out-of-the-money amounts) of Puts is higher than the price of Calls:

The options open interest on TLT is less clear, because the leaps have higher Call open interest than Put open interest, however the nearby February ‘09 options show higher Put open interest than for Calls:

• Feb ‘09 $120 Put OI = 875, Call OI = 611
• Jan ‘10 $120 Put OI = 200, Call OI = 141
• Jan ‘11 $120 Put OI = 106, Call OI = 47

Yes, read about and listen to views. Consider what professionals who devote themselves to market analysis have to say. Analyze their arguments, their biases and their conflicts using a critical mind, but also watch the prices, and the futures and the options before you decide to put your money down.

Sometimes the markets (crowds) are right, and sometimes they are wrong. Short-term, markets are more right than wrong most of the time, because until they end, trends are self perpetuating. You just need to recognize the endings. Easier said than done, but it can be done.

We tend to think there is a short-term reversal in the making for the T-bond. Intermediate-term, we have no view. Long-term, rates must rise and bonds must fall.

POST SCRIPT:

We published this article as a follow-up to our “Treasuries Bubbly - Will Disappoint” articles of December 24 and 25, only to discover the day after we published that the lead story in Barron’s is “Are Treasuries Safe?”. Since Barron’s articles tend to be market movers, being aware of their well distributed thoughts is a good idea. They said;

Long-term Treasuries now yielding less than 3% could fall 25% in value as the recession ebbs and rates rise … it’s time to consider alternatives, like munis yielding up to 6% and even junk bonds paying 20%.

We aren’t so sure about the recession ebbing, but we think Treasury rates could rise anyway, as yield seekers look elsewhere, and as major buyers such as China, Japan and the UK demand more for their money in the Treasury markets.

They quote Mohamed El-Erian, co-CIO of PIMCO (operator of PIMCO Total Return — PTTPX, the largest bond fund in the US) as saying “Get out of Treasuries. They are very, very expensive.”

They expressed concerns about inflation following the “super-accommodative” Federal Reserve policy, and and about the likely sequence of asset rotation out of Treasuries into higher yielding debt, and then to equities as the economic situation improves. That is a point we have been making and that still makes sense to us.

Treasuries were the beneficiaries of fear and they will be abandoned by the once fearful, when they feel the market storm has past. The improvement is likely to occur, and seems to be occurring, first in other debt classes earlier and more dramatically than in equities. This chart we put together shows the recent price changes by capital type, supporting the idea of price improvement cascading down the capital structure from highest quality bonds toward common stock at the bottom of liquidation priority.

[securities in image: TLT, MUB, LQD, HYG, PFF, SPY]

Barron’s likes inflation protected Treasuries (see our TIP of TIPS from Dec 26) which they think could earn over 5% annual yield over the next 10 years if inflation averages 3%, it’s recent historical norm.

They say the consensus is now that Treasuries will fall. However, they point out that the Merrill Lynch economist, David Rosenberg, is concerned that “imploding” household wealth and the prospect of a 3% contraction in the US economy in 2009, and perhaps into 2010, could push 10-year Treasury rates to 1.5%. That scenario would be a bull case for Treasuries.

We think getting of the way of currently declining long-term Treasuries is prudent.

Comments

[SW Richmond:]

Very thorough and informative examination of long maturity Treasuries, and a subject much on everyone's mind.

You did not even mention QE and I am puzzled buy this omission. On the other side of any trade in Treasuries is a man with a printing press and the stated intention of using it. Timing this bubble will be the trade of the century, and that timing has everything to do with Bernanke.

There are several different ideas floating around. The obvious dilutive impact to Treasuries of monetization / QE is well understood by our foreign creditors and it will be avoided as long as possible. I suspect (and it is only suspicion) that Treasury rates will be kept low for as long as possible, and certainly until Treasury has issued a large chunk of new debt in longer-maturity issues.

If you could provide your thoughts on QE and monetization I would really appreciate it.

Jan 04 09:09 AM

[Isnt_It_Jus...:]

Implied volatility of the Feb ‘09 $120 put on TLT is 36% while that of the call is 33% so it is correct that the market is biased to the down side on TLT. This is the proper way to decide market bias based on option prices not "because the price of Puts is higher than the price of Calls".

Jan 04 09:52 AM

[SwingTimer:]

SW Richmond
What is "QE"?

Jan 04 10:04 AM

[appone:]

QE should stand for "Quantitative Easing"

Jan 04 10:36 AM

[QVM Group:]

SW Richmond:

I probably should have mentioned quantitative easing specifically, but have been focusing on the inflation that must follow current deflation due to flooding of the markets with increased money supply. QE is just an extreme form of what has been going on. My prior articles were more focused on that aspect of the problem. Thanks for commenting.

Jan 04 01:35 PM

[QVM Group:]

Isnt_It_Just_Money

Your addition of volatility information is helpful, and I encourage investors to look at multiple dimensions of options, but I reject the notion that volatility is the "correct" data to interpret (and by implication that price is the "incorrect" data to interpret). There is nothing incorrect about comparing the price of two related securities (in this case two essentially inverse options). For our purposes, in this instance, price is the preferred indicator of what we are seeking to understand.

Jan 04 01:41 PM

[Isnt_It_Jus...:]

But the puts are $4 in the money, of course they are more expensive than the calls, which are out of the money. Price doesn't tell you anything.


On Jan 04 01:41 PM QVM Group wrote:

> Isnt_It_Just_Money
>
> Your addition of volatility information is helpful, and I encourage
> investors to look at multiple dimensions of options, but I reject
> the notion that volatility is the "correct" data to interpret (and
> by implication that price is the "incorrect" data to interpret).
> There is nothing incorrect about comparing the price of two related
> securities (in this case two essentially inverse options). For our
> purposes, in this instance, price is the preferred indicator of
> what we are seeking to understand.

Jan 04 01:55 PM

[QVM Group:]

Isnt_It_Just_Money

You are quite right about in the money issues. We have a clerical error in our data recording that we are correcting at this time, thanks to your sharp eye. The conclusion is the same, but the data is inaccurate. We will correct the post on our site and then ask SA to correct that portion of this republished articles. You have done us a service in pointing our our clerical mistake. However, with adjustments for in and out of the money, prices are useful in our view -- but we need to be more tidy in our data transpositions.

Jan 04 02:17 PM

[SW Richmond:]

Mr. Shaw,

I've just read three of your earlier pieces, they've given me a lot more info including your thoughts on QE, thanks a lot!

It's a remarkably dangerous game that Treasury and Fed are playing, and it is one that all of us are watching closely.

I started buying small lots of TBT some time ago and have taken a beating; I still agree that Treasuries are 'bubbly'. Treasury 'supply' is overwhelming.

Jan 04 02:26 PM

[Kunst:]

With all the stimulus and bailouts going on, the Fed and the US government are pouring money into the economy. Granted it is replacing lost capital, but it still pushes the money supply up compared to a more passive approach. With Obama's stimulus plans, the federal budget deficit could be in the $1 trillion annual range for the next two years. If they finance this by selling treasuries on the open market, that increase in supply should push prices down and rates up. If the Fed buys treasuries to keep rates down, it creates new money that will push inflation up, which will also put upward pressure on rates. Either way, it's hard to see how treasury rates can go anywhere but up.

Jan 04 03:55 PM

[The Sage of...:]

The demise of an investment in Treasury bonds has been a theme repeated for a number of years now. Perhaps it's finally true. I analyzed the returns on five year treasury bonds for the last thirty five years. The assumption was that the individual investor purchased the five year "on the run" Treasury bond and sold it at the end of the year crystallizing the capital gain or loss and repurchasing the five year bond for the next year. In this way, the investor always held a five year bond. I believe that the bond return slightly outperformed the returns on the Dow Jones Industrial Average over the corresponding period. If this is incorrect, comments appreciated. If this is correct, perhaps a review of the longer term outlook is warranted.

Jan 04 06:00 PM

[QVM Group:]

Sage:

This chart may relate to your comment.

www.qvmgroup.com/VFINX...

It plots the return of the S&P 500 versus long-term Treasuries over 19 years as represented by two Vanguard funds.
As of now, stocks would have been nothing more than a bother, unless rebalancing between stocks and bonds was done, in which case the result would been superior.

Jan 04 08:29 PM

[drone:]

Haven't the Chinese, Japanese, et al made substantial gains on their US treasuries this year? Won't they keep buying? Thus keeping prices buoyant

Jan 04 08:34 PM

[drone:]

They all need to buy bonds - lots of bonds, like old people. Where else can they get these bonds?


On Jan 04 08:34 PM Terry Huebert wrote:

> Haven't the Chinese, Japanese, et al made substantial gains on their
> US treasuries this year? Won't they keep buying? Thus keeping prices
> buoyant

Jan 04 08:46 PM

[dawase@gmai...:]

Question: When the Chinese or the Koreans or the Saudis talk about diversifying their reserves away from the Dollar, how do you think they accomplish this?

Answer: They buy Government bonds from countries OTHER than the United States. Or maybe they buy some gold. Virtually anything other than US treasuries.

Jan 05 02:36 AM

[SW Richmond:]

Sage / Mr. Shaw,

I'd like to stand back and look at the long wave.

I think it's fairly well understood that a regime of steadily falling interest rates is bullish for stocks. This chart:
research.stlouisfed.or...
shows that long rates have been falling more or less steadily since the mid-1980's. Rates are now at or near historic lows.

A long term DOW chart shows it's response to this steady lowering of rates: steadily rising stock prices since the mid-1980's. The DOW reached historic highs, stumbled, and has thus far failed to respond to further lowering of interest rates. This article
www.plexus.co.za/files...
includes a chart titled "The Marginal Utility of Debt in Real Terms" which shows that new dollars of debt have much less of a stimulative impact on the economy, as specified in this quote from the paper: 'In the 1960s, real total debt outstanding in the U.S. "bought" $0.64 in additional real GDP. In the current decade, a dollar of real additional debt now "buys" $0.15 in additional real GDP.'

I wonder, as I am sure do others, whether we are essentially at the end of a credit super-cycle. I also follow the writings of Antal Fekete, and one of his main theses is the idea that a regime of falling interest rates destroys capital. It seems that this makes some sense if you consider what also started to happen in 1980: raising interest rates drastically. Higher interest rates encourage savings over consumption and hence are supportive of capital and thence capital formation. The high rates encouraged capital formation and launched a new productive economy. Over time we have continually lowered interest rates to try to avoid adjustments (recessions), but have had to do so more and more due to the gradually reducing marginal utility of debt. We have now reached the end of the cycle. We will inflate away the old debt, endure a bout of inflation, everyone's lifestyles will be reduced to pay for all the consumption we brought forward with the debt, real resources such as gold and oil will go to the moon, and then we'll raise interest rates and have another recession to restart the process.

The conclusion I draw is that we essentially need to "reset" the capital process. Ultimately it will look like we raised interest rates to suppress inflation (still to come), but what we really will have done is to re-enable savings and make capital formation possible again.

I'd really appreciate your thoughts.

Jan 05 12:43 PM

[SW Richmond:]

Forgive me "piling on" here, but this article also illustrates the end game of capital destruction. The capital pool is completely depleted, and lowering interest rates further won't work. The bubble will not reinflate; printing money dilutes capital, adding to its destruction. Low rates make new capital formation impossible.

www.telegraph.co.uk/fi...

'Millions of savers are braced for zero per cent accounts within days as the Bank of England is poised to cut interest rates to the lowest level in its 315-year history.'

Jan 05 01:29 PM

[Market Folly:]

solid article, thanks for contributing it. would agree with your assessment but would add that one should be patient with putting on the short longer-term treasuries play (via long TBT or short TLT) because it could take longer to play out than many realize. we do, though, think that it indeed does play out and that inflationary pressures eventually return. we gave our "shorting treasuries" rationale here: www.marketfolly.com/20...

Jan 05 08:37 PM