Is the T-Bond Bubble Bursting?

In the months after the last round of the credit crunch hit, yields on treasury securities fell to unprecedented lows. However, since the start of the year they have been increasing quite rapidly -- most notably in the longer maturities.

Based on the closing yields last Friday, the one-year note has moved up in yield (down in price) only slightly since the end of 2008, rising to 0.42% from 0.37%. The yield had been pretty stable at much higher levels before the fall wave of the credit crisis struck, yielding 2.12% at the beginning of September and 2.19% a year ago.

However, longer-term securities are giving up bigger chunks of their gains. Right now, the five year T-note is yielding 1.69%, up from 1.55% at the end of the year, but down from 3.00% at the beginning of September and 3.51% a year ago.

Similarly, the 10-year note is now at 2.66% up from 2.25% at the end of the year, but well below the 3.74% level at the beginning of September and 3.51% a year ago. Likewise, the 30-year bond has reversed direction, now yielding 3.38%, up from 2.69 at the end of the year, but down from 4.36% at the beginning of September and 4.23% a year ago.

So far, this reversal seems like good news, in that it could be indicating people are willing to do something with their money other than hide in treasuries. However, think of it as a warning shot across the bow: the government is going to have to raise an incredible amount of money this year, to both roll over existing debt and to fund the stimulus, bailouts and the huge pre-stimulus deficit. Almost all other governments are doing variations on the same theme.

This large demand could well start to crowd out other borrowers. Rising rates, particularly on the longer-term securities, could also be in response to fears that the huge growth in the money supply will reignite inflation down the road. They will also tend to cause mortgage rates to rise, and choke off the rebound in housing sales that we started to see earlier this week.

Also, one of the most compelling arguments for investing in the stock market right now is that the earnings yield (inverse of the P/E ratio) is extremely attractive relative to longer-term treasury yields. Based on 2009 expectations as of Thursday, the earnings yield on the S&P 500 is 8.62%. That, however, is likely to come down sharply as earnings expectations fall.

Then again, even in a "worst case" scenario where 2009 expectations fell in half from current levels, the earnings yield would still be well above the current 10-year note yield. A rise in the T-note yield would cut into the validity of that argument.

Life insurance companies tend to be major holders of long-term debt, and the reversal in longer-term treasury yields is another headache for firms like Hartford (HIG) and Metlife (MET).

Comments

[sheridan:]

I agree long term but short term this market will be manipulated by the Fed via quantitative easing and could see a few shocks to the upside- probably a 2 year trade.

Jan 28 08:50 AM

[Chris B:]

Look at what is going on in Europe. Rising yields and buyer shortages are coming.

More concerning is what will happen when all those financial institutions that piled into long term treasuries have to mark-to-market that value of those low-yield treasury bonds, which will have fallen dramatically in value due to higher rate bonds being available. Treasuries' prices fall a lot faster than their yields rise.

US banks are using their accounts at the federal reserve banks not just to hold reserves, but as a safe place to hoard all their cash! The observed exponential increase in M0 demonstrates this. However, I suspect that their treasury exposure, and especially the treasury exposure of foreign banks, will turn into write-downs of similar magnitude to the early days of the mortgage crisis.

Losses in treasuries could finish off the last of the weakened big banks, even the most "responsible" ones, leaving behind a world of small retail outfits or government zombie shell banks. I'm not sure who will be left standing in the new, deconsolidated financial world, much less how they will make money, so I'll avoid the sector all together, but keep a wary eye on it.

Jan 28 09:27 AM

[elliot_mllr:]

In answer to Chris B's last sentence, the ones left standing will be owners of TIPS.

Jan 28 09:56 AM

[Moon Kil Woong:]

The Treasury bubble won't have to be confronted unless the economy recovers which seems to me like the Fed and Treasury are betting against that scenario. When it does, everyone on this board is correct that the Treasury losses will pull the banks and the economy right back down again. Thus we will be stuck just like Japan was with their quantitative easing policies of the past.

Nice work Bernake and Paulson. You get an F in economics.

Jan 28 02:48 PM

[X-15:]

Great comment Chris B...........

Jan 29 10:52 PM

[orangequant:]

did a radio show last night on HIG, PRU, MET--- next week, the show is looking for forums to visit and traders to watch and call in live with their comments--- 646-727-1893
last night's show archived at
www.blogtalkradio.com/...


On Jan 29 10:52 PM X-15 wrote:

> Great comment Chris B...........

Jan 31 04:36 PM