Treasuries Struggle Alongside Stocks

Last week, 30-year Treasuries posted their biggest weekly loss since 1987. Normally, one might expect the capital leaving bonds to move into equities, and yet stocks fell. I'm not patting myself on the back, but if you've been reading my articles over the last three weeks, you know this is exactly what I have been predicting. Of course, I think the move is going to be much more pronounced over the next year or two.

But then, if you've been reading my articles, you also know that I exited my short position in Treasuries (through the double short ETF, TBT) after a big part of the move. So you're undoubtedly asking yourself why, if I am so bearish on Treasuries, did I offset my position?

Believe me when I tell you that, with every move lower in Treasuries last week, my stomach tightened a little more. Yes, I believe the reversal is going to be colossal -- just like the collapse in oil. And no, I do not want to miss it. But unlike the oil bubble, there is a huge variable in the Treasury equation that makes timing of the move much more difficult: the Fed.

In December, when the Fed lowered its funds target to between 0% and 25%, it also stated it would use any tools at its disposal to fight the ailing economy -- citing specifically the possibility of buying the long-end of the yield curve to keep rates as low as possible. As most of you know, I think such a policy would be extremely stupid -- bad for both Treasuries and the dollar; the move would undoubtedly necessitate more printing of money by the Fed, only adding to inflationary pressures, and it would undermine the credit-worthiness of the United States, calling into question successful future Treasury auctions.

Listen, I'm no market-timer. In fact, I hate looking for entry- or exit-points. Usually, I'm a buy-and-hold guy, but these are crazy times, and they require extreme diligence, patience, and perseverance. It's true, I believe Treasuries and the dollar are doomed, and if the currency I'm being forced to use is going to fall apart then I'm going to try to get on the opposite side of that catastrophe -- as anyone would. At the same time, I'm not going to lock myself in a cage and provoke a fistfight with a gorilla as big as the Fed.

For almost all of 2008, I waited. I wanted to short Treasuries all the way down, but somehow I knew, even with the specter of rising prices looming early in the year, things were about to get bad. I knew if credit continued to dry up, people would start selling whatever they could to raise cash, and that would mean an economy-wide collapse in asset prices. I knew about Japan in the 1990s and early 2000s. I knew about Bernanke's dream to be a helicopter pilot. Yes, yields were low, but shorting Treasuries was still too much of a risk if the Fed took us to zero. And that's exactly what it did on December 16.

Only then did I sell, and I did well -- thanking my lucky stars that I hadn't shorted earlier in the year, thinking about all the poor souls who did. Timing really is everything in a game like this.

The only reason the Fed would threaten to attack the long-end of the yield curve is that it can't lower its funds rate any further. It needs to be able to continue fighting a weakening economy; indeed, unless I'm missing something, the only reason it wouldn't buy long-term Treasuries would be if it saw a strengthening economy and a return to risky investment. But that's not what the Fed is seeing: unemployment is moving dramatically higher. Consumer confidence continues to stagnate. Equity markets are hovering at multi-year lows. Housing starts and existing home sales are imploding.

Nothing is getting better; if anything, things are getting worse.

I'm going to make my next prediction with a lot of hesitation, because I actually think the prediction may be wrong. If it is, I'm probably going to miss the move in Treasuries I've been salivating over for the last year. But here it is anyway:

Because the Fed is not seeing the sort of signs that might signal an impending recovery, it probably will start targeting the long-end of the curve. And when it does, I believe there's a distinct possibility it will do so with strength and decisiveness. Remember, one of the Fed's biggest criticisms of Japan's failed zero-interest-rate-policy -- and subsequent quantitative easing -- is that the Japanese central bank failed to act with decisiveness and strength -- that is, they neither acted quickly enough, nor with enough firepower to get any real results.

On another note -- and adding to my trepidation about the Fed's intervention -- is the fact that the Japanese yen continues to strengthen against every other major currency in the world. Remember, Japan's well-being depends heavily on its ability to export, and a strong currency is horrible for exports. Japan can't allow its currency to continue to strengthen much longer -- especially against the dollar -- and one of the best ways to weaken the yen is to buy Treasuries. The Chinese are in the same boat.

So to round out my prediction: I think it's highly possible that some, or even all these factors might come into play over the next weeks or months -- especially if we continue to see weakness in equity markets. In that regard, I want to reiterate that the consumer is tapped out, and as such, I believe corporate earnings are going to continue to fall across the board -- probably drastically. As many of you know, I believe credit card companies are extremely vulnerable to defaults on a vast amount of unsecured debt, and on top of all the other pressure the economy is facing, I believe commercial foreclosures are going to accelerate, along with unemployment. Any of these alone would be bad for stocks, but taken together they could cause more catastrophic losses.

What could all this mean for the Treasury market? Well, despite the fact that I believe there is neither "quality" nor "safety" in Treasuries, the consensus has traditionally been against me. This could lead to a lot of pressure driving Treasury prices higher -- perhaps even retesting some of the levels we've seen in recent months. Of course, because of the cracks we've seen in the last week, I think we're starting to see signs that Treasuries will not necessarily be perceived as the safest place to park money indefinitely, and if we do see another downward run in yields, I'm going to jump right back in with even more zeal than before.

Until then, I'll sit and watch. Hopefully my stomach won't contract too much.

Disclosures: None.

Copyright 2009, Paco Ahlgren. All Rights Reserved.

Comments

[dakyne:]

I think that's what he's fearing--hence, he's not re-entering the TBT trade, which is a bet on rising yields and lower bond prices. If the Fed does start buying the long end, it will stimulate demand for bonds, driving up prices, and yields down.

One thing he did not address is the huge upcoming bond offerings this week. If the auctions aren't well-received, and there are few buyers, that will exert downward pressure on bond prices. He kind of accounted for one scenario where the Japanese will buy bonds (and sell yen) to weaken the yen, but there are other large sovereigns who normally purchase US Treasuries for their reserves, namely the Chinese, Saudis, and Koreans--all of whom are declaring they no longer find yields on US Treasuries appetizing. With huge supply being auctioned off, and little demand, rates will rise. I agree that the Fed will intervene which will temporarily drop yields, but that is a short-term move which will prove problematic long-term for the reasons he mentioned.


On Jan 25 04:18 AM The hand wrote:

> the fed has threatened to start buying treasuries. how does that
> play into your scenario?
>

Jan 25 04:33 AM

[JohnAl:]

Yep, sit and watch is my strategy at the moment too. All I've been doing is getting myself in position to move and move quickly. That and educating myself on what the heck is going on.

Bernanke and the new administration seem to be ready to try anything and Congress more than willing to let them try whatever they propose. Little is predictable at the moment, other than that they will be doing something. People expect them to "do something", so they WILL continue to "do something".

The only thing they WONT try is doing nothing.

Jan 25 04:38 AM

[dakyne:]

There are other reasons why sovereigns find US Treasuries at these yields distasteful:

1) future threat of inflation over the next 30 years (risk profile at these levels are potentially catastrophic)
2) they already have too much exposure in the dollar in their reserves, which is being debased by monetary easing.
3) Because of deteriorating fundamentals of the dollar, the Chinese and the Saudis are diversifying their reserves into gold, which is a hedge against debased currencies (worldwide).

Basically, there is growing distrust in the US government, and by extension, its monetary policies and the dollar. At some point, US Treasuries will no longer be viewed as havens in a flight to safety and quality.

That's when the game will be over, as rising rates will render servicing of the national debt untenable. In other words, these trillion dollar bailouts won't be free lunches, and the burden will be placed on tax payers to fund, even though the American consumer is already tapped out. God help us all if the US Government loses its AAA rating--the UK is on the brink due to its teetering banking industry.

On Jan 25 04:33 AM dakyne wrote:

> I think that's what he's fearing--hence, he's not re-entering the
> TBT trade, which is a bet on rising yields and lower bond prices.
> If the Fed does start buying the long end, it will stimulate demand
> for bonds, driving up prices, and yields down.
>
> One thing he did not address is the huge upcoming bond offerings
> this week. If the auctions aren't well-received, and there are few
> buyers, that will exert downward pressure on bond prices. He kind
> of accounted for one scenario where the Japanese will buy bonds (and
> sell yen) to weaken the yen, but there are other large sovereigns
> who normally purchase US Treasuries for their reserves, namely the
> Chinese, Saudis, and Koreans--all of whom are declaring they no longer
> find yields on US Treasuries appetizing. With huge supply being
> auctioned off, and little demand, rates will rise. I agree that
> the Fed will intervene which will temporarily drop yields, but that
> is a short-term move which will prove problematic long-term for the
> reasons he mentioned.

Jan 25 04:45 AM

[morph366:]

When yields on 10 year notes plunged in early December they were in completely uncharted territory - no technical indicators could help. On the re-test of the very low yields around 2% at the end of December there was a non-confirmation in terms of MACD, RSI etc. The pattern from a technical point of view is suggesting that there is less urgency and momentum in the flight to safety dynamic.
To redress this and to see a new momentum/panic low we would almost certainly need to see yields below 2% which could happen but seems a bit of a stretch.

Jan 25 08:14 AM

[ArtfulDodger:]

Dear Paco:

Thanks again for your interesting piece. I wish you well on your T-timing short. That's too much work for me, though.

As I mentioned to you before, I think sector- and nation-specific equity plays are the place to be for the most part.

I would not touch these US sectors with the Fed's phony money: auto, retail, financial, real estate.

I wish others well at picking through those trash dumps for treasures.

I would avoid Russia and Europe for the time being. I'm sure there will be winners there (perhaps big ones), but I'll let others sift through the dumpsters to find them.

I like China. The Chinese are determined to be a major business force in the world, and I can't see anything short of a major upheaval and turnover in leadership that can stop them.

There are some excellent companies in China today worth investing in. They would surely meet and even surpass a Buffett/Munger analysis.

You are right. Many of our banks are in serious trouble, but not all of them are. Many have turned down TARP funds.

I believe that eventually the government is going to realize that either it can't save the dying dogs or it will take all their worthless loans and assets off their hands; and then and only then will investors return to them. I don't like the latter, but it's a recourse I believe the government is considering.

And I definitely think you're right about Ts, but when they crash I believe investors will flock to stocks. Not every sector, but certain ones.

Also, I want to point out that at no time in history has our government ever poured this type of money into the system. In prior Keynesian arm shots we're looking at about 1% of GNP or less.

Today, between the Fed and the Treasury, we're looking at what looks to be over 15%.

Now, we do know that monetary policy will work, but it takes from a year to fifteen months for it to show up in the economy.

But what all the rest of the money will do is another question. We can only guess in my view, because the amount is so unprecedented.

So much money will have to have an affect, and yes (opposite your view), I do believe there is a demand for all those dollars, which will, of course, hold down the price increase effect that such inflationary action could otherwise cause.

Jan 25 09:20 AM

[Wesley Mouch:]

The effectiveness of the federal reserve monetizing the debt on the long end of the curve is extremely counter-intuitive. The damage to the currency should equally offset any federal budget increases financed through the method (if it works without currency valuation consequence, isn't it a mythical money machine?). Furthermore, the desire for any person or country to hold long dated treasuries with such a policy being conducted is weakened in anything but the short term. Central planners in China have alluded to a reduced desire to continue to purchase treasuries, and that the US can't borrow its way out of this mess.

More importantly however, the idea that the economy as a whole can be fixed with lower interest rates is also weak. This is not our grandparents recession. The rate could be zero for a 30 year fixed rate mortgage, but if the buyer is not credit worthy, he will not get the loan. Don't damage the currency and faith for rate suppression that won't be effective anyway.

Secure the safety nets, arrange for orderly foreclosures, and retrain workers for a fundamentally different economy producing tradeable goods and services.

Jan 25 09:41 AM

[Conan the B...:]

It is almost like clockwork. Yields go up prior to an Auction to get buyers interested, yields go down after the auction making the buyer happy.

What is the point of trying to analyze this activity?

What the Treasury rates do inbetween auctions should be compared not just right before one. My opinion.

My question would be whether there was a perceived lack of interest in this auction? Did Geithner run off at the mouth to get yields up and buyers in?

Jan 25 12:18 PM

[kelm:]

Great post! Both bonds and equities are on a knife edge right now. You are right to be very cautious of the Fed coming in - and if they can figure out a way to do it when the markets are not formally open they will - just like they do with currency intervention.

Conventional wisdom is "don't fight the Fed" this time the Fed s having to fight global issues. So can the Fed beat the world? I don't think so. There will be some massive tug-of-wars but ultimately rates are headed up and the dollar headed down.

Jan 25 12:31 PM

[Truefire:]

Nice analysis, the Fed is playing a very dangerous monetary game here. The ever strengthening yen is the key aspect as well as Geitners comments on China's currency manipulation to maintain a week remnibi.

The Fed is leveraging the dollars reserve status assuming that the other central bankers will be forced to keep pace & not let the dollar be weakened by Fed purchases of treasuries which weaken the dollar.

What if they are wrong? I think we all know the answer. I got a bad feeling about this one.

Jan 25 01:09 PM

[MGA_1:]

So, who would actually purchase a 30 bond that yields 3.25%? This can't last. The fed may decide to decide to buy these suckers which, IMO, will means inflation. What's worse is if the chinese and japanese stops buying our bonds - or even worse - selling them. Watch out ! What people will find out is that a 10 year bond can actually *lose* money.
I don't know when it's going to happen, but I'm predicting the bursting of this bubble will be the beginning of a bad currency crisis, the inability of the govt to get funding and inflation... possibly worse.
Right now I'm shorting tbills, then heading into gold.

I hope the US comes out of the end of this ok.

Jan 25 01:13 PM

[henarl:]

Can the Fed buy long treasuries as fast as everyone else is selling them, including other countries, funds, trusts, banks, individuals, etc., without causing at least double digit inflation? - I don't think so. Long TBT and staying with it.

Jan 25 04:12 PM

[secmaven:]

For buy and hold investors TBT is a no brainer.

Jan 25 05:37 PM

[vaughn:]

Thanks to the ZIRP, both the money market and the treasury repo market are basically collapsed. Ben Bubble Bailout Bernanke will do anything to preempt a treasury bubble burst. Yes, Ben will monetize the treasury for as long as he can, currency or inflation be damned.

Like the collapse of the oil commodity, Ben cannot prevent the treasury bubble from bursting forever. But he sure can hold it for a short term, be a few months to a couple of years.

Jan 25 09:28 PM

[Conan the B...:]

Paco: Once upon a time in the East, Japan Was a major exporting nation.

As of today, Jan. 25, 2009, Exports account for Just 16% of Japan's GDP. Bloomberg TV. Japan's stimulus package is based on trying to get the Public to spend. Stimulating such a small section of their GDP is a waste of Yen.

Jan 25 10:43 PM

[Conan the B...:]

Paco: I suggest you find out what percent of Chinese GDP is represented by their exports. Last year, I saw an estimate of just that just 6% of their work force was involved in the Industrial sector. It is probably even less currently.

You made some statements about both of these nations regarding the importance of exports for their respective economies, which led to your conclusions.

Where did you get the data that supports the contention that the Well Being of both Japan and China are dependant on their ability to export?

Jan 25 10:56 PM

[igggy:]

I think if the fed starts buying treasuries everyone and their mother will know it's time to sell. Besides, it would be a really dumb way to waste taxpayers money. Why not buy higher yielding and more economy-relevant securities: even more mortgage bonds, munis, more corporate paper. I can see a not-so-clean balance sheet and potential conflicts of interest but that's still better than 'easing'.

On the other hand, I find the following analysis credible:
www.hoisingtonmgt.com/...
low yields just might be here to stay for a while.

Jan 26 01:56 AM

[Conan the B...:]

Dtv999: The Treasury issues, the Fed buys the issues.
The money stays In House but the Treasury can issue more.

The question then becomes: how much can the Fed buy, is there a ceiling? And does Congress get involved?

If Congress gets involved, then its time to run for the hills.

Jan 27 01:47 PM

[Tetrapod:]

Great article and great timing! I bought TBT on Dec 24 and it was up 25% as of yesterday. Today, I saw what looked like intervention to me with huge bursts of treasury buying that pushed TBT down over 5%. I sold, not wanting to fight the Fed, or whatever sovereign is doing the buying.

I'll be back in whenever market behavior returns.

Jan 27 04:33 PM

[gdog:]

If the foreign banks go to gold, the effect will be the same. Euro currencies are in the same trouble as the dollar, and if the chinese don't want treasuries, than what? US equities? Gold? Guess whose got the gold market cornered, and the US gov't usually does everyone a favor by keeping the price in check.

But if us creditors stop believing in us credit worthiness, this implies extreme US asset appreciation. It's just paper after all.

Basically us asset to debt ratio increases as the dollar devalues if treasuries are rejected, it will just happen immediately as the world falls apart, instead of over a controlled period of time. Not a situation that anyone wants.




On Jan 25 04:45 AM dakyne wrote:

> There are other reasons why sovereigns find US Treasuries at these
> yields distasteful:
>
> 1) future threat of inflation over the next 30 years (risk profile
> at these levels are potentially catastrophic)
> 2) they already have too much exposure in the dollar in their reserves,
> which is being debased by monetary easing.
> 3) Because of deteriorating fundamentals of the dollar, the Chinese
> and the Saudis are diversifying their reserves into gold, which is
> a hedge against debased currencies (worldwide).
>
> Basically, there is growing distrust in the US government, and by
> extension, its monetary policies and the dollar. At some point,
> US Treasuries will no longer be viewed as havens in a flight to safety
> and quality.
>
> That's when the game will be over, as rising rates will render servicing
> of the national debt untenable. In other words, these trillion dollar
> bailouts won't be free lunches, and the burden will be placed on
> tax payers to fund, even though the American consumer is already
> tapped out. God help us all if the US Government loses its AAA rating--the
> UK is on the brink due to its teetering banking industry.
>
> On Jan 25 04:33 AM dakyne wrote:

Jan 29 03:55 AM

[jeerio:]

I got lucky and bought TBT two weeks ago, so I'm up 20% on what I imagined would take a bit longer, lol. While my longer-term trading experience tells me to sell and enjoy the profits, I can't seem to actually pull the trigger. And while the temptation is great to double-down on such a winning position, I don't think that's advisable either.

From all the posts I've been reading in the area of Treasuries, gold, inflation, etc., I believe the prudent thing is to simply play the field with an asset allocation approach. Chances are all the things being prognosticated will happen and none of us know the sequence, duration, severity or driving forces in advance.

Too often we all can fall into the trap that prescribes "The Way it Has to Happen" - a neatly arranged package of events that make perfect sense yet never actually occur the way we think they will.

The entire system is broken and rules from the past no longer apply. The real wild card is the psychic damage done to the consumer and the sectors that are being pummeled. Patience is the key since new eras need to find their way in a fashion that frustrates even the most seasoned and highly-lauded thinkers.

Just like over-trading, over-prognosticating typically wears thin and unprofitable fairly quickly.

The reality is, if I continue to hold this original (1200 sh) position in TBT, I expect it may lose the 20% already gained. At That point, I'll be even more convinced that I'm on the right track, and would likely increase the position. There's something viscerally meaningful about being in the game as opposed to simply talking about it, especially when you know perfectly well that timing is rarely on your side.

Jan 31 12:58 AM