Speculators Fight The Fed Once Again In The Bond Market: Can They Finally Win One?

Includes: EDV, SPY, TLT, ZROZ
by: DoctoRx

Score one for persistence! Small speculators in the futures markets, unbowed by numerous losses the past five years, are again bearish on Treasuries. They are shorting bonds at a fraught time given this week's Federal Open Market Committee (FOMC) meeting. Here is the setup on the futures market, first a one-year view, then a multi-year view, from FINVIZ:

To review, this shows the positioning of the three classes of participants on the futures exchange in the U.S. The green line shows the commercials, which take the opposite side of the trade from the speculators. The speculators are divided into large and small traders (red and blue lines). The large traders are usually hedge funds or large commodity pools. The small traders are everyone else. All players in this market are "smart money," at least in theory. However, many feel that small traders might include some John Q. Public trend-followers, some of whom might be better gambling in Vegas or on Powerball than with the sharks in the futures market.

Higher prices represent lower interest rates.

If we look at the top chart, we see the double top in the summer. Then we see something interesting. There is a broadening downtrend with a megaphone formation. Connecting the highs of the summer, late fall, and April-May gives a mild downtrend. Obviously there is a sharp downtrend connecting the various lows. Betting that this downtrend will continue involves massive chart risk, even if interest rates have finally entered a prolonged and perhaps secular uptrend. Bonds can be in a downtrend even if the price spikes sharply, just so it remains within the pattern of lower highs that's been established since last summer.

In any case, the blue line represents the positioning of the small speculators. This winter they got pretty bearish, with the blue line a good distance below the zero line. Lo and behold, bond prices soon rose. As prices have dropped, they have piled on their (winning) negative positions.

We should look at the positioning on the multi-year chart of the commercial hedgers, represented by the green line. In the past years shown, they were often going against the large traders. Large traders are very smart money (at least often they are), yet they kept losing to the commercials time after time. High levels of commercial longs through this time period show: Don't fight the commercials!

We must keep in mind that going short a secure bond is on its face a bit of a strange thing to do. One owes the interest on the bond, and assuming one is on margin (it is the futures market, after all), one is paying margin interest. So from the get-go, shorting a bond is an expensive proposition. One does not have the luxury of time to be proven right and still make money, the way one can sit with a stock or gold coin for years and be right if it moves enough years after purchase, after going nowhere or down year after year. Further, there will be no Enron in the U.S. Treasury market (or so I predict). The bonds will not collapse near zero. They will pay off. So it's difficult to see the upside from shorting these boring debt instruments that, after all, underpin so much of the national and global economy.

Also, whoever shorts a Treasury bond is clearly fighting the most important man in the history of 21st century finance, and perhaps one of the most important men in the entire history of finance.

Why does anyone want to do this? Is this a hubristic thing to do? (I leave aside the question of patriotism, if the short position is being taken on by an American.) Can't Dr. Bernanke merely give a hint the right way and cause an explosion of buying into Treasuries?

Furthermore, the yield on the 10-year bond is now a bit higher than that on the SPDR S&P 500 ETF (NYSEARCA:SPY). This bond also yields a point or more than inflation, as judged by the CPI or the Fed's favored inflation indicator, the PCE (which is at a multi-decade record low of 0.7% annualized). Finally, the yield curve is steep. Fed funds have actually been in a mild downtrend lately. Shorting the long bond from here (30-year bonds look similar regarding positioning) when the yield curve is reasonably steep is aggressive.

In muni-land, yields are actually attractive relative to inflation, suggesting that there may have been excessive flight from bonds in general. From Yahoo! Finance, a section of its Composite Bond Rates section from Monday's closing yields shows this:

(Click to enlarge)

(Click to enlarge)

I actually added some A-rated munis to my portfolio on Monday, drawing down cash balances to do so. Given today's high marginal tax rates, I think these yields are not even close to bubbly. Yet you read everywhere about a bond bubble. Where is there a bond bubble when you can lend to an A-rated municipality of the United States for 10 years and receive the equivalent of a taxable yield over 4% if one is in a high tax bracket, with the near-certainty of the timely return of your entire principal?

It is the very existence of these reasonable valuations that makes me wonder if those who are shorting the Treasury bond are simply making the basic error of taking a position after a trend is well-established, but the fundamental reason for the trend to start (rich valuations in this case) has quietly evanesced away.

It is worth reviewing the long-term view of interest rates. As I see it, they are back into their downtrend channel (which of course may have ended). Courtesy of multpl.com:

(Click to enlarge)

This chart proves that at least going back to 1871, the historical anomaly was the surge in the late 1960s of interest rates to historic highs at 6%. The 10-year bond only left that yield range behind in 2001. We are really only two years into the abnormally-low range below 3%.

The linked page also states that the median interest rate for the last 142 years is 3.92%. Again, the historical anomaly was the 1970-1990 period, not the 2001-2011 period.

The last time yields on the 10-year went below 3% followed the Great Crash, circa 1929-33. It then took about 25 years to go north of 3% and stay there. Perhaps we have 23 years of ultra-low bond rates left! (That to date has certainly been the Japanese experience.)

It is thus difficult to see a case to actively short the 10-year bond here. (Again, I oppose doing so on patriotic grounds, and want to make sure the NSA knows I think that way!) Inflation is low, precious metals are merely hanging around bear market lows, bond yields have already had a large percentage surge up from their lows, and Ben Bernanke told Congress just last month that the economy is not ready for higher rates.

My view is that for taxable accounts, intermediate-to-long term tax-exempt bonds are reasonable investment alternatives now.

Speculators and investors who might want to bet on Dr. Bernanke prescribing an effective remedy to help heal the bond market this week, or soon, may do so many ways. A small investor who does not want to buy Treasuries outright but wants to express a point of view about bonds via an ETF will find maximum liquidity via the iShares Barclays 20+ Year Treasury ETF (NYSEARCA:TLT), which owns ultra-long term Treasury bonds. After expenses, this BlackRock product yields about 3% right now. Less liquidity but more dramatic market moves come from ownership of zero-coupon Treasuries via two ETFs. These are the PIMCO 25+ Year Zero US Treasury Index ETF (ZROZ) and the Vanguard Extended Duration Treasury ETF (NYSEARCA:EDV). These are riskier than TLT due to the greater volatility of zero-coupon bonds, which pay no current interest. Each of these ETFs may all be considered both for speculative trading and as possible buy-and-hold investments. If the latter, because dividends (interest and/or capital gains) are taxable, they are best suited for tax-deferred accounts. In an appropriate proportion, they may be suitable in my view as a form of portfolio insurance. (I in fact own them as a hedge against something like the Japanese interest rate scenario continuing here in the U.S. Also please be aware I am not a registered investment adviser.)

While we all know that the interest rate structure of the Treasury bond market is heavily influenced by the Federal Reserve, the 10-year Treasury has ceased to be directly influenced by Operation Twist, which ended at year's end. Thus it has had time to "decide" on its new trading range. There is no sense at this point at looking at the trend of this bond and treating it as if it were a biotech stock and trying to ride the bullish wave. Those who are shorting this bond, perhaps from following the current trend, are fighting Ben Bernanke, and my final thought is:

Caveat shorter:

Shorter beware.

Disclosure: I am long TLT, ZROZ, EDV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Not investment advice.