Could Investors Be Wrong (Again) About Treasury Bonds (TLT)?

Over the last 20 years, inflation has come down because many of the items we buy, such as big screen LCD TVs, have got cheaper as a result of technological innovation and the relocation of production to low-wage countries.

Last December many investors flew into iShares Barclays 20+ Year Treas Bond (TLT) for its safety and pushed its price from $95 to $120 within a month. It was a “treasury bubble”. Sooner or later every bubble bursts, the bearish sellers outnumber the bullish buyers and greed flips into fear. Bombarded by inflation fear, investors sold TLT as low as $90. People are switching from stocks and bonds to investments with more protection from inflation, such as iShares Dow Jones US Real Estate (IYR), Oil Services HOLDRs (OIH) and SPDR Gold Shares (GLD). Is Inflation an immediate threat as investors feared?

Niall Ferguson, author of The Ascent of Money, states that sometimes the most important historical events are the non-events: the things that didn’t occur. The most significant economic event of the era since World War II is something that has not happened: there has not been a deep and long-lasting depression.

Now, we might finally see one. On June 22, the World Bank has cut its 2009 global growth forecast, saying the world economy will shrink by 2.9 percent.

Inflation and recession were regarded as mutually exclusive. Many people argued that with close to 10% unemployment rate and only two thirds of production utilization in the U.S, it is hard to see inflation on the horizon.

However, you could see both. Stagflation is an economic situation in which inflation and economic stagnation occur simultaneously. Governments printing money caused a combination of inflation and economic stagnation in Europe after World War I. A more recent example was the 1970s.

The U.S government’s annual deficit of nearly $1.5 trillion is 10% of its GDP, a number never approached since the 1930s Depression. Who is going to buy all of this debt?

Estimates suggest gross Treasury issuance of up to $3 trillion this calendar year and net offerings close to $2 trillion – almost four times last year’s supply, according to Bill Gross, Managing Director of PIMCO, the world’s largest bond fund. The first and most recent development is the steepening of the U.S. Treasury yield curve and the rise of intermediate and long-term bond yields. He once said: “Bond markets have power because they’re the fundamental base for all markets. The cost of credit, the interest rate, ultimately determines the value of stocks, homes, all asset classes.”

It used to be high yield bonds such as iShares iBoxx $ High Yield Corporate Bd (HYG) behaved like stock. These days treasury bonds have been more volatile than regular bonds. For example, following chart shows iShares Barclays 7-10 Year Treasury (IEF), TLT, SPDR Barclays Capital Intl Treasury Bond (BWX) and Vanguard Total Bond Market ETF (BND). Among them the least volatile one is BND.

As John M Keynes once observed, in a crisis “ markets can remain irrational longer than you can remain solvent”. In the long term, it might be true the market is always coolly logical. However, in the short term, it is inhabited by emotional human beings, capable of flipping suddenly from greed to fear.

There are too many unknowns. Could U.S interest rates stay low for

long, like Japan? Could the situation in Iran be out of control, causing investors to fly to “safety” (of treasuries) again? UltraShort 20+ Year Treasury ProShares (TBT) has been in the market for only over a year, but its assets are double the size as TLT’s, which has been around for more than 7 years. For a conservative investor, seems like the only choice for fixed income is iShares Barclays TIPS Bond (TIP).

Disclosure: I have a long position inTIP

Comments

[logicalthought:]

I'm all for "expecting the unexpected", but under what realistic scenario could U.S. interest rates stay low, no matter how bad the economy is? (And I do think it will continue to be bad.) When you combine the amount of upcoming Fed issuance with the declining demand from foreigners (due to decreasing U.S. imports), it seems to me that rates will have to stay high in order to attract buyers. And if the Fed monetizes the debt instead, rates will soar due to inflationary fears (which is why I think the Fed won't do it). Thus, I think we'll see what is perhaps the worst of all economic worlds: high rates combined with DE-flation, an environment in which cash will truly be king.

Jun 23 07:07 AM

[texpat:]

Before he became Fed chairman, Bernanke was already on record as favoring turning up the printing presses to prevent deflation (what became called the "helicopter drop"). And the Fed is currently talking about QE to buy Treasury debt. Do you think that all of this is misdirection or that they're going to have a sudden change of heart?

On Jun 23 07:07 AM logicalthought wrote:

> if the Fed monetizes the debt instead, rates will soar due to inflationary
> fears (which is why I think the Fed won't do it). Thus, I think we'll
> see what is perhaps the worst of all economic worlds: high rates
> combined with DE-flation, an environment in which cash will truly
> be king.

Jun 23 08:48 AM

[CoinMiner:]

I agree that there remain a number of unknown variables out there, which make this market such a tricky one to play. However one thing I'll wager is that geopolitical uncertainty, such as "Iran out of control" - the example used above - rarely forces long term yields much one way or another.

Think of it this way - when was the last time you heard an investor say/blog: "Gee, that government is collapsing and their neighbor doesn't look so hot either - think I'll go buy more government paper promises!".

Not likely; the higher probability bet is they'll increase their defensive positions in short term cash, commodities and gold, and local real estate.

Jun 23 09:45 AM

[logicalthought:]

Texpat:

This is a fair question, and I will give you an "outlier" of an answer: Yes, I think that Bernacke will (to use your phrase) "have a change of heart", due both to his own introspection and pressure from the rest of the Fed and wiser heads outside of government (but certainly not from the Dems in Congress-- I'm not THAT naive). I really think that he won't want to go down in history as the guy who destroyed the U.S. dollar, and he will thus force the country to accept the delevering pain we should've already started a while ago.

On Jun 23 08:48 AM texpat wrote:

> Before he became Fed chairman, Bernanke was already on record as
> favoring turning up the printing presses to prevent deflation (what
> became called the "helicopter drop"). And the Fed is currently talking
> about QE to buy Treasury debt. Do you think that all of this is misdirection
> or that they're going to have a sudden change of heart?
>
> On Jun 23 07:07 AM logicalthought wrote:

Jun 23 10:59 AM

[Bull Run:]

Mondays US treasury auction, the Fed bought $7.5 billion, maturing between '16 and '19 of the $20.7 billion auctioned or about 1/3 of the total auction. Does this make sense? If the Fed doesn't continue to support the tresury market, what would the rates really be? A Central bank is considering QE, it prints money to purchase exsisting government backed debt to increse the Money supply. I'm OK with that.. Common central bank monetary policy. My problem with the US monetary policy is that at the same time they're buying their debt back, they're printing more debt, which is supposed to have the opposite effect, it takes money out of the system..Why not just forget printing Tresuries and just print US dollars. It's more blantant, but it's more true to the facts. Who cares what other nations think, the US has never cared in the past.

Jun 23 11:42 AM

[igggy:]

>The U.S government’s annual deficit of nearly $1.5 trillion is 10% of its GDP, a number never approached since the 1930s Depression. Who is going to buy all of this debt?

When the stock market appears too risky and money market accounts yield 0.5%, people start buying Treasury bonds. They may not buy 30 or 10-year treasuries at first but that might be just a matter of time. The yields are fairly attractive.

In fact, I have recently seen an article on SA saying that treasury holdings among US investors have gone up recently. People have to put their money somewhere and the new oil bubble can only last so long. I myself put some money into a Vanguard long bond fund expecting 10-20% appreciation by the end of the year.

Jun 23 01:38 PM

[Tony Daltorio:]

Can you say Bubble? The Treasury market continues to be the biggest bubble in history.

As Tim Iacono said - It's amusing to see all of those financial market players who play musical chairs in their "flight to quality", not realizing how rickety the chairs really are.

Jun 23 03:35 PM

[The Virginian:]

Igggy - Demand for US Treasuries will plummet as the world's central banks and governments run from quantitative easing-debased US dollars. The debt of countries engaged in currency debasement HAS NEVER been safe to own. It's not the default risk (which is probably nil), but the risk of converting the foreign debt to local currency that makes the risk so disproportional to the reward. It doesn't matter if EVERYONE in the US decided to buy UST - the continued divestiture of China, Japan, Russia, et al. will create a tsunami of supply that will ultimately drive yields into the stratosphere. Printing money KILLS BONDS. Period.

I take no joy in seeing our nation's creditworthiness and currency destroyed, but it is happening at a breathtaking pace which, I fear, is irrreversible. There was a reason a roomfull of Chinese students recently laughed at Tim Geithner's comment to them that their country's investments in US Treasuries were "perfectly safe."


On Jun 23 01:38 PM igggy wrote:

> >The U.S government’s annual deficit of nearly $1.5 trillion is 10%
> of its GDP, a number never approached since the 1930s Depression.
> Who is going to buy all of this debt?
>
> When the stock market appears too risky and money market accounts
> yield 0.5%, people start buying Treasury bonds. They may not buy
> 30 or 10-year treasuries at first but that might be just a matter
> of time. The yields are fairly attractive.
>
> In fact, I have recently seen an article on SA saying that treasury
> holdings among US investors have gone up recently. People have to
> put their money somewhere and the new oil bubble can only last so
> long. I myself put some money into a Vanguard long bond fund expecting
> 10-20% appreciation by the end of the year.

Jun 23 06:47 PM

[Loucleve:]

repeat after me - there is no inflation. not with 10% unemployment. the world comes back to its senses, and realizes no quick recovery, china binge buying commodities be damned. now buy treasuries.

the answer is in the article - the short treasury fund is now 10 times bigger than TLT. what do you need, a sign?

Jun 23 07:51 PM

[Loucleve:]

excuse me, twice the size of TLT. sorry, but it does not change my opinion.

Jun 23 07:52 PM

[Mad Hedge F...:]

I don't think so. For those who missed the 70% move in the TBT this year, the double short Treasury bond ETF, another window is setting up for you to get in. After running up from $35 to a meteoric $60, we have backed off to $50. Similarly, the bond futures, which plunged from 142 to 112, have bounced back up to 118.5. I think the prospect of a retest of this year’s stock market lows triggered a lot of flight to safety buying of government paper in the last few weeks. If we don’t get that retest, which I think is unlikely, then it’s back to the races for the TBT. Things certainly aren’t getting any better on the fiscal front. According to the Congressional Budget Office, the national debt is now growing so fast, that it will reach 100% of GDP by 2023, seven years earlier than was predicted only 18 months ago. Some 90% of the increase came from burgeoning Medicare and Medicaid spending. It seems that hardly a week goes by without Congress passing another humongously expensive package that has wonderful long term benefits for the economy and society, but has to be paid for with hard cash dollars up front. Watch the TBT.

Jun 26 01:28 PM

[JR Ewing:]

Iggy I am no bond expert but you can't get a 10 -20 percent return at these levels, you missed that boat. That boat has a hole in it now and you will be lucky not to lose money to higher yields or inflation.

On Jun 23 01:38 PM igggy wrote:

> >The U.S government’s annual deficit of nearly $1.5 trillion is 10%
> of its GDP, a number never approached since the 1930s Depression.
> Who is going to buy all of this debt?
>
> When the stock market appears too risky and money market accounts
> yield 0.5%, people start buying Treasury bonds. They may not buy
> 30 or 10-year treasuries at first but that might be just a matter
> of time. The yields are fairly attractive.
>
> In fact, I have recently seen an article on SA saying that treasury
> holdings among US investors have gone up recently. People have to
> put their money somewhere and the new oil bubble can only last so
> long. I myself put some money into a Vanguard long bond fund expecting
> 10-20% appreciation by the end of the year.

Jun 27 04:48 PM