Is It the Right Time to Short Treasury Bonds?

In his new book, The World Is Curved, David Smick argued that today’s world economy bears a striking resemblance to the integrated markets and overwhelming prosperity of the period from 1870 to 1914, which was an extraordinary episode in the economic progress of mankind. Similar to today, that was a period punctuated by continual financial crises and of great prosperity.

This Friday US 10 year bond approached 3% again (2.9960% to be exact). Lots of people believe the next great and only bubble left is treasuries. Is it the right time to short treasuries?

In the near future (12–18 months) bond prices might be down (yield up) for the following reasons:

1. Waning Fed’s influence

The U.S. Treasury and the Federal Reserve are flooding the markets with money. In the meantime, they are doing everything in their power to keep interest rates low, including keeping the short-term rate between 0 – 0.25% and buying treasuries. However, the power of central banks, such as the US Federal Reserve, is diminishing. According to a McKinsey report, there are 4 new powers in the global financial systems which control over $10 trillion in total: oil exporting nations ($4T), Asian central bankers ($3T), hedge funds ($2T) and private equity.

Since 2004, the Fed’s influence over long-term rates mysteriously began to wane, though it can still control short-term interest rates. The reason the Fed no longer has full control of its interest rate policy is because long-term rates became a captive of global financial forces.

2. Institutional Investors Reducing Bond Holdings

Institutional investors are gradually reducing pure bond positions and increasing investment in real assets. For example, since December 2007, The California Public Employees’ Retirement System ( CalPERS), the largest state pension fund, allocated about 10% of its fund to a hedge against inflation, such as TIPS.

3. Credit Crunch

Ongoing de-leverage and new restrictions by government would produce a global credit contraction for quite a while. Today’s credit crisis is no longer the size of subprime mess or asset-backed securities. The issues were where the toxic assets were located: “Who had the cancer and who is healthy”. Ultimately it comes down to information, transparency and trust. There are no quick fixes for the global credit system's crisis. It might take a few years, if not longer, to fix and regain trust. If it costs a mid-size company 14% to borrow money, there is no reason treasuries would stay at this low level for long.

4. Overcapacity

As emerging markets continue to add capacity, we are entering into a long-trend of overcapacity, not only in the manufacturing sector, but also in services. As a result, the global economy would suffer shortage of natural resources and inflation would accelerate.

I compiled the following list of the 12 biggest and most popular bond ETFs, including government bond, invest grade corp bond, high yield and short. All these ETFs have asset over $1 billion.

Category	Name	Ticker	Expense
Short-Term Bond	iShares Barclays 1-3 Year Credit Bond	CSJ	0.20%
Short-Term Bond	Vanguard Short-Term Bond ETF	BSV	0.11%
Intermediate-Term Bond	iShares Barclays Aggregate Bond	AGG	0.20%
Intermediate-Term Bond	iShares Barclays MBS Bond	MBB	0.25%
Intermediate-Term Bond	Vanguard Total Bond Market ETF	BND	0.11%
Intermediate-Term Bond	iShares Barclays TIPS Bond	TIP	0.20%
Long Government	iShares Barclays 20+ Year Treas Bond	TLT	0.15%
Long Government	iShares Barclays 7-10 Year Treasury	IEF	0.15%
Long-Term Bond	iShares iBoxx $ Invest Grade Corp Bond	LQD	0.15%
High Yield Bond	iShares iBoxx $ High Yield Corporate Bd	HYG	0.50%
Short Government	iShares Barclays 1-3 Year Treasury	SHY	0.15%
Short Government	iShares Barclays Short Treasury Bond	SHV	0.15%

As you can see from following chart which compares iShares Barclays 20+ Year Treas Bond (TLT), iShares iBoxx $ Invest Grade Corp Bond (LQD) and SPY over the last 5 years, both TLT and LQD had an inverse relationship with SPY. So bonds should still be a vital part of your well diversified portfolio.

Source: Yahoo Finance as of 04/24/09.

The more certain a trend seems to be, the higher the chances of a reversal, or is it?

Disclosure: Author has a long position in SPY and TIP

Comments

[whidbey:]

This is interesting, but hardly conclusive. The power of the Fed to buy the long end of the curve down (and push prices up) is still exceptionally great. I look for USB to rise to 145 before it falls any. For that reason you must expect the bonds you have listed to rise in price and fall in yields for the next 6 months approximately. Your inverse SPX observation is helpful and true, but the market will make a new run soon (after to little correction) to about 900 SPX (After that 4-6 months rally), I suspect something dreadful will happen, but that is another story. One travesty at a time.

Apr 26 08:44 PM

[MarkitWacha:]

You forgot TBT, the double inverse long bond ETF.

This is the one people should keep in their 401k, because of 401k trading restrictions.

Apr 29 09:12 AM