When Will the Treasury Bubble Burst?

2008 was one of the best years on record for U.S. Treasury bonds. The iShares Lehman 20+ Year ETF (TLT) - a good proxy for 30-Year Treasuries - gained 23% over the year. However, Treasuries seem to be winding down an unprecedented bull rally, with rates retracting from historical lows.

The big question on traders’ minds is when will the Treasury “bubble” burst? It is still too early to tell, but TLT has taken a big dip over the last two trading sessions, down 4.55%. It should be noted that this occured over low volume holiday trading, but with general equity market volatility, as measured by the VIX, subsiding, this could be the start of a broader bond bust.

With the federal government balance sheet worsening by the day, Treasury fundamentals stand on shaky ground. General macroeconomic conditions stand at odds with bond market action over the last few months. With global asset values crumbling, institutional investors engaging in forced mass liquidations, and foreign governments picking up USD and short-term Treasuries to offset reserve losses, our currency reversed a six year slide and government bond yields dropped to shockingly low levels.

These rates may not mean much to the casual observer, but consider that the 5-Year, 10-Year, and 30-Year Treasuries yielded as high as 3.796%, 4.32%, and 4.813%, respectively, at their highs this year.

Starting with the October equity market crash, there was a global “flight to quality”. During the panic government bonds were bid to ridiculous levels; for instance, 3-Month bills were yielding just 0.01% last month, after briefly dipping into negative territory. This means people were giving the government their money without expecting anything in return!

Looking at the yield curve over the last month, it appears as though Treasuries have been retreating from their peaks. The panic seems to be subsiding, and with it the quality premium investors were willing to pay to hold government bonds. TLT’s 4.55% drop may spell the beginning of a snap back to normalcy, or much worse: there is always the risk that America’s fiscal irresponsibility will brand our debt “junk.”

This week will be more telling than the previous, as traders return to work from the holidays and regular volume resumes. Holding onto Treasuries at these levels is only justifiable if you anticipate pervasive, long-term deflation. If not, now is as good a time as ever to rebalance your portfolio and unload some Treasuries. Speculators should start to look at shorting government debt, starting with longer term maturities.

Disclosure: Author holds a short position in TLT

Comments

[Tradememe:]

The Treasury bubble will be the shortest of all. As soon as the panic psychology subsides, people will go back to their usual preferred investment vehicle.

Jan 05 06:01 AM

[User 321933:]

Good points and I am pretty damn bearish but I dunno if this will be The Great Depression...I'm thinking that this is a Lost Decade but we'll do it better cause we are da USA

Jan 05 09:11 AM

[Chris B:]

There are literally trillions of dollars in losses baked into this treasury bubble. Why is no one asking what the big-picture consequences of those losses will be?

-Will the foreign governments that the US relies on for financing change their opinion of treasuries from "safe" investments to potential money losers? Will those fresh losses push up risk premia and yields after the recovery even higher than they would otherwise be?

-How exposed are the banks? Losses on treasuries will not be subject to mark-to-model accounting as mortgages were, they will have to be written down each quarter, even if the bank plans to hold until maturity. And if they do hold until maturity, how will the banks ever profit when so much of their outstanding loans are to the govt at 0%? Are they now effectively, Japanese-style zombie institutions?

-How many more pension plans will be going bust?

-How much of the treasury bubble is a symptom of capital flight from other currencies, and what is the consequence for the dollar when that capital flight inevitably reverses?

Jan 05 09:41 AM

[henarl:]

Why would anyone tie their money up for 3 months at 0% when they could just put it under the mattress at the same return and better liquidity ? People are just thoughtless lemmings. Duh!
Check out TBT today to see what is already happening to long treasuries.

Jan 05 01:16 PM

[Shannon Melton:]

Here are some strong arguments about not only the bubble bursting, but what may be next.

experienceiseverything...

Jan 05 02:20 PM

[Market Folly:]

we've advocated a long TBT position (essentially short TLT) as we think inflationary pressures sink in again. rationale is outlined in our november post: www.marketfolly.com/20...

Jan 05 08:30 PM

[Umpa:]

You see, the more shaky the Q1 reports come in after the G20 Summit, the higher the US dollar will be as the world will make further flight to safety by buying up US Treasury bonds, and US dollars. US dollar should skyrocket to 1.40 CAD. The bubble will burst, but not yet. I bet that the rally for the dollar is not yet over, and the dollar is still in the bull market stages.

Mar 29 11:51 AM