Maybe the Bond Market Is Right

In a previous post on long term Treasury bonds, I reviewed some of the technical factors that have me bearish.

So it is highly likely, from this perspective, that Treasury bonds will be an under performing asset class over the next 12 months. But more importantly, will this market top lead to an investing opportunity (i.e., by shorting Treasury bonds)? In other words, will the market top lead to a secular trend change in Treasury bonds?

On this, I am a little less certain. As we know, many (i.e., see the Barron's story, "Get Out Now") are calling for a top in Treasury bonds, yet as I contend, market tops don't occur when we all expect them too. Furthermore, I wonder if betting against bonds is a good strategy as a bet against Treasury bonds is a bet against the US Government. The Federal Reserve and Treasury have made their intentions known and are likely to support bond prices.

But what if bond market participants are right? What if they are buying not because there is a flight to safety (due to losses in other assets), but because they see value in borrowing at 0% and buying long dated Treasuries that yield between 2-3%? In a deflationary environment such as seen in a recession, this certainly makes sense.

In essence, buying bonds is really a bet that the Fed's reflationary policies will not work. Buying bonds is a bet that our economic malaise will continue much longer, and this notion is clearly supported by the data. See figure 1, a monthly chart of the yield on the 10 year Treasury bond. The indicator in the lower panel is an analogue representation of the National Bureau of Economic Research's (NBER) expansions and contractions. The NBER is the government organization that officiates over the beginning and ending times of a recession.

On the graph, the gray vertical bars highlight recessions. The relationship between Treasury yields and economic contractions is easily seen. It would be highly unusual for yields to rise during a recession.

click to enlarge images

Figure 1. 10 Year Treasury Yield v. NBER/ Monthly

Let's look at the relationship between Treasury yields and economic activity in another light. See figure 2, a monthly chart of the yield on the 10 year Treasury bond. The indicator in the bottom panel is 12 period rate of change of the Leading Economic Indicator data from the Economic Cycle Research Institute. As noted in a prior commentary, there is a very strong correlation between negative indicator readings and contracting economic activity. The gray vertical bars highlight economic contractions.

Figure 2. 10 Year Treasury Yield v. ECRI LEI/ Monthly

In 10 out of the 11 instances sited, long term Treasury yields headed sharply lower during the economic contraction. The lone exception was in 1974, and yields went higher only to retrace that move once the expansion took hold.

If the past relationship between Treasury yields and economic activity is any guide, we should not see Treasury yields rise while the economy is contracting. However, once the Fed's policies begin to take hold and when the economy begins to expand, then it would seem more probable that a secular trend change for yields is on the horizon.

My bearishness on Treasury bonds is based upon the 'next big thing" indicator, which is a tool that I have developed that helps me identify the potential for a secular trend change in an asset. I have shown this indicator in figure 3, which is a monthly chart of the 10 year Treasury yield with the NBER data in the middle panel. Recessions are identified with the vertical gray bars and peaks in the indicator, which correspond to a bottom in yields, are noted with the maroon colored bars. The indicator is in the extreme zone, and once again, suggestive of a top in bonds or at the very least, Treasury yields should not go much lower.

However, the real story of figure 3 is this: bottoms in yields don't come during economic downturns, and more often than not a bottom in yields will come once the economic expansion is well on its way.

Figure 3. 10 Year Treasury Yield v. NBER v. "Next Big Thing"/ Monthly

It does not seem likely that long term Treasuries will sell off (i.e., leading to higher yields) until the economic landscape improves. However, given the size of the Fed's stimulus response so far that sell off could be brutal once our economic fortunes improve. Given that the "next big thing" indicator is in the extreme zone, it is worthwhile keeping this asset class on the radar screen.

Comments

[Hefaistos:]

Thanks, excellent article. It would be nice to complement this analysis also with the real, inflation-adjusted yields. Especially since we now have deflation, meaning that real yields are higher than nominal ones.

At the end, you say "...bottoms in yields don't come during economic downturns, and more often than not a bottom in yields will come once the economic expansion is well on its way". I agree with you, the turnaround might be quicker this time. Any indication that the bailout and packages give the intended effect, that we see some signs of economic expansion, will bring about a flight from the treasuries. This might be a rather unique trading opportunity.

Jan 16 04:49 AM

[User 143167:]

So the author means that Fed is actually fighting against itself. If the UST yield doesn't move up, the reflation failed. If it does move up, the Treasury and Fed will have a harder time to refinance its own debt. So it sucks either way.

Jan 16 05:08 AM

[Credit Crun...:]

I'm not so sure about the "...bottoms in yields don't come during economic downturns" argument. In Russell Napier's "Anatomy of the Bear" (an analysis of the bottom of four bear markets - 1921, 1932, 1949 and 1982) he concludes that "a recovery in government bond prices precedes a recovery of equities. In 1932, equity prices bottomed seven months after the government bond market. In 1921, 1949 and 1982, the lags were 14, nine and 11 months respectively". Thus, on the past history of major crashes, we should expect Treasuries to fall and yields to rise as the downturn continues.

Jan 16 05:22 AM

[peterthepai...:]

fear is the key...greed is on hold...

many people are in treasuries for safety not returns...

it's the return of their money!...not a return on their money...

they are not there for the long term...only sheltering from the storm...

Jan 16 07:06 AM

[wdhalgren:]

At this level, US bonds are a good long term short no matter what the economy does. If we have a prolonged economic slowdown, US govt default risk will begin to rise as pension plans implode, banks wither, the housing market continues collapsing, the stock market nosedives further and employment really starts to take a hit. All of those factors serve to either decrease US govt revenues, or increase US govt liabilities. A prolonged economic slump could raise issues with servicing the US public debt, forget worries about long term repayment of principal.

Now couple the above factors with reduced household consumption as debt service becomes unbearable for the average American, thus lower imports from places like China and Japan. This lessens the need for purchase of US treasuries by foreign central banks, as there is less US current account deficit to support. Throw in some trade wrangling, and fcb's may well become net sellers of UST's. The only solution is massive printing of dollars to purchase that debt, which of course is extremely dollar negative.

No matter the economic path from here, fire or ice, US treasury bonds are a very good long term short. Just don't overleverage.

Jan 16 09:01 AM

[notsosmart:]

i dont think history with all its charts & graphs matter here.you cant figure on lying gov.figures,lying ceo's,selfserving boards, secret deals & entities,lack of ethics & transparency.little or no accountability.trust is gone even though some may still rate it AAA.LOL

Jan 16 10:46 AM

[User 337526:]

remember though the possibility still exists for the treasury to earn a positive carry thru its investments in the financials, etc...plus when you borrow at 2%, its not hard to earn a return on that borrowing...


On Jan 16 05:08 AM User 143167 wrote:

> So the author means that Fed is actually fighting against itself.
> If the UST yield doesn't move up, the reflation failed. If it does
> move up, the Treasury and Fed will have a harder time to refinance
> its own debt. So it sucks either way.

Jan 16 11:34 AM

[kelm:]

It is a concern that everyone is seeing a top. Whether it is or not seems to depend on whether the Fed can keep interests rates at rock bottom (through the quantitative easing strategy) while supporting a deficit that will exceed $2 trillion this year? It seems that when the point comes that the debasing of the US dollar is finally recognized and the money starts to leave the country interest rates will either have to be allowed to rise or the dollar will be allowed to become worthless. The wisdom is always "don't fight the Fed" but can the Fed fight the world withdrawing their money and support a monster deficit?

Jan 16 01:34 PM