Don't Bet Against the Bond Market

Yesterday's 7-year treasury auction went very well. The new 7-year U.S. treasury note drew a yield of 3.005 versus an expected 3.047. The financial media was eager to explain the strength of the auction away. For instance, Bloomberg News credited (blamed) weaker-than-expected existing home sales data for the flight to U.S. treasuries. If one merely looks at the surface, that explanation would appear to be accurate. However, we do not stop at the surface around here.

A dead give away that existing home sales were not the driving force behind the strong 7-year auction is the indirect bid data. Indirect bidders, which includes foreign central banks, purchased 61.7% of the new issue. According to U.S. treasury data, indirect bidders purchased an average of 46.2% of the past seven 7-year auctions. Although some smaller investors may have been motivated to participate in yesterday's auction because of the existing home sales data. Foreign central banks take a big picture approach to treasury purchases and it is very likely that the majority of yesterday's indirect participation was decided upon days in advance (if not longer) of yesterday's auction.

What do foreign central banks know which would encourage them to continue to purchase large quantities of U.S. treasuries at historically low yields in the face of a strong stock market? The answer is that indirect bidders may buy treasuries, but they do not buy the V-shaped recovery argument.

Foreign central bankers know that U.S. economic growth will be hindered by poor consumer activity over the next several years. They know that problem is not a lack of bank lending, but a rediscovery of prudent lending standard. The U.S. economy (and global economy) has enjoyed ever-cheaper credit and ever-lax lending standards. The party is over folks. Look at all the charts you want, the past IS NOT an indication of the future (man, I sound like a mutual fund). Seriously, one cannot look at past cycles, isolate a repeated trend and automatically assume it has to happen again and again. One must also consider the extenuating circumstances. The Fed is not perfect, but I believe it to be accurate when it states that growth will be modest in the near future.

It is the possibility, if not probability, of muted growth that is keeping long-term yields low, for now. This leaves fixed income investors in a quandary. Overweight the long end and you are caught with your pants down when long-term yields finally move higher. Overweight the short end of the curve and your income stream is so low it is almost impossible to catch up even if one extends out on the curve at a later date at higher yields. We would need Carteresque economic conditions to make market timing rewarding in the treasury markets.

Also, investors should understand the difference between fixed income investments which are interest rate products and those which are credit products. U.S. treasuries are interest rate products as they have no credit risk. Short-term securities, such as T-bills and short-term notes, trade at yield levels which reflect Fed policy. Longer-term yields, such as those found with 10-year notes and 30-year government bonds reflect inflation expectations. If bond investors believe that inflation pressures are going to be mild, they are willing to invest on the long end of the curve at modest yield levels as they do not believe inflation will be present which will erode the value of their fixed cashflows.

Credit products, such as corporate bonds, trade at yields which reflect interest rate projections AND the perceived creditworthiness of the issuer. It is possible for corporate bond yields to behave quite differently than treasury yields. We have had two good examples during the past year. Last year as the banking system was pushed to the brink of collapse, credit spreads for financial companies widened out. This caused corporate bond yields to rise. At the same time, treasury yields fell as the Fed lowered short-term rates and investors bought treasuries across the yield curve in a flight to safety from corporate debt to government debt. Corporate bond yields moved in the opposite direction of treasury yields. This makes some portfolio stress tests useless as they tend to stress a fixed income portfolio for specific moves in interest rates,. Most stress tests cannot account for the behavior of credit yields. Many do not account for the changing shape of the yield curve due to Fed policy and inflation expectations. Long-term and short-term yields more often than not do not move in lock step with each other. In fact, they may not even move in the same direction. Always contact a fixed income professional before venturing into the fixed income markets.

So which market is correct in its forecast for the U.S. economy? Don't bet against the bond market.

Comments

[John Galt:]

> The party is over folks. Look at all the charts you want, the past IS NOT an indication of the future (man, I sound like a mutual fund). Seriously, one cannot look at past cycles, isolate a repeated trend and automatically assume it has to happen again and again. One must also consider the extenuating circumstances. The Fed is not perfect, but I believe it to be accurate when it states that growth will be modest in the near future.


And hence the term NEW NORMAL. Bravo sir, you get it. Now many people here will disagree with you and call you nuts ( the playbook around here is gold & inflation), but in reality they won't be arguing with YOU... They will be arguing with the MARKET.

Sep 25 09:17 AM

[Fund Insider:]

Investing in the long or short end of the curve depends not just on economic forecasts (and who can ever predict that with certainty), but also on your purpose for being in Fixed Income. If you are managing a purely FI portfolio (maybe a retiree or institutional FI portfolio), then these bets are what you are paid to make. If you are an asset allocator (typical younger to middle age investor or balanced fund manager) then you need to consider other items, such as whether your bond portfolio truly offers diversification from your equity or other assets. Going with mmkt or short bonds there is no reverse (or any) correlation. I often consider this short/long conundrum discussed here, but in the end, I remind myself that the purpose of my FI portfolio is to offset the risk of my equity portfolio.
There are days I make money in stocks, lose in bonds, and vice versa. A portion of my FI portfolio is just for this purpose. Other portions I use to make specific bets, such as when I loaded up on corp bonds during the peak of the crisis (time to start thinking about getting out now ???). Point is, your strategy for FI investing should be based on your goal(s), not just on the markets and yield curves.

Sep 25 09:19 AM

[Bernard Thomas:]

Bingo, you get it. No everyone does.


On Sep 25 09:19 AM Fund Insider wrote:

> Investing in the long or short end of the curve depends not just
> on economic forecasts (and who can ever predict that with certainty),
> but also on your purpose for being in Fixed Income. If you are managing
> a purely FI portfolio (maybe a retiree or institutional FI portfolio),
> then these bets are what you are paid to make. If you are an asset
> allocator (typical younger to middle age investor or balanced fund
> manager) then you need to consider other items, such as whether your
> bond portfolio truly offers diversification from your equity or other
> assets. Going with mmkt or short bonds there is no reverse (or any)
> correlation. I often consider this short/long conundrum discussed
> here, but in the end, I remind myself that the purpose of my FI portfolio
> is to offset the risk of my equity portfolio.
> There are days I make money in stocks, lose in bonds, and vice versa.
> A portion of my FI portfolio is just for this purpose. Other portions
> I use to make specific bets, such as when I loaded up on corp bonds
> during the peak of the crisis (time to start thinking about getting
> out now ???). Point is, your strategy for FI investing should be
> based on your goal(s), not just on the markets and yield curves.

Sep 25 10:17 AM

[chap08:]

"What do foreign central banks know which would encourage them to continue to purchase large quantities of U.S. treasuries at historically low yields in the face of a strong stock market? The answer is that indirect bidders may buy treasuries, but they do not buy the V-shaped recovery argument."

Sorry, this is the argument I just don't buy. I've recently swapped foreign stocks for treasuries in reasonable scale, as a hedge. But longer term, they're just a bad investment. They are propped up by foreign central banks - not for any of the reasons you discuss - but simply because of their trade policies. They need to do it for the sake of their domestic economies. It's nothing to do with a view on the recovery. Without support from foreign governments, the dollar would fall hard and yields would jump. This won't be happening any time soon, but I don't want to be around when it does.

Sep 25 11:17 AM

[Mad Hedge F...:]

wsc Reviewing the current political and monetary landscape, I would be remiss, irresponsible, even negligent, if I didn’t revisit one of my favorite ETF’s, the Proshares Ultra Short Treasury Trust (TBT). This is the 200% leveraged bet that long Treasury bonds, the world’s most overvalued asset, are going to go down. While the Fed is going to keep short rates low for the indefinite future, it has absolutely no direct control over long rates. The only political certainty we can count on is the continued exponential growth in the supply of government bonds of all maturities. Like all Ponzi schemes, their eventual collapse is just a matter of time. It’s simply a question of how many greater fools are out there (sorry China). Look at how they are trading now. We currently have the greatest liquidity driven market of all time, and the ten year is only eking out a 3.40% yield, pricing in near zero inflationary expectations. The average yield on this paper for the last ten years is 6.20%, a double from the current level. Get the yield back up to 5%, a distinct possibility in 2010, and that takes the TBT from the current $45 to $70. Sure, we may get a sideways grind in yields for a few months, which will be expensive due to the mathematic idiosyncrasies of the 2X ETFS. But a security that is unchanged if I am wrong, and doubles if I am right is the kind of risk/reward ratio that I will take all day. And I believe that in my lifetime Treasuries may lose their vaunted triple “A” rating and be priced closer to subprime (warning: I am old). That could enable the TBT to deliver the holy grail of trades, your proverbial ten bagger.

Sep 25 12:15 PM

[RIP DXO:]

(Full disclosure: we used some of the cash from DXO to buy TBT . . .)

Sep 25 12:44 PM

[TxTim:]

Bernard

I think you're a smart guy but I didn't read anything that acknowledges unprecedented Fed QE, unprecedented trade deficits over the last several years, and a staggering level of US Gov't debt on the backdrop of a proposed healthcare plan with an incomprehensible cost. Maybe not now but at some point investors will begin to evaluate what "risk free" really means. At this point in time it's beginning to look more and more like nothing more than the ability to PRINT money, not the ability to REPAY money with balanced budgets and taxes. The gov't is on the playing field and is distorting the market you are evaluating. At some point the piper must be paid for printing money. Didn't Friedman say something to the effect that everywhere and always inflation is a monetary phenomenon. You just can't print $ 1.75 trillion without having some effect.

Sep 26 04:08 PM

[Tony Daltorio:]

I totally disagree with the author - I do NOT invest in bubbles and the Treasury market is the BIGGEST bubble I have seen in nearly 30 years in the investment industry.

And I'm not a gold bug as John Galt seems to suggest that everyone is who disagrees with the article.

Sep 27 09:46 AM

[Bernard Thomas:]

No one is saying that long-dated treasuries ase a stellar investment. The are a less poor choice. The U.S. economy is going to function with prudent credit, not loans for everyone. However, until foreign exporters can find a replacement for the U.S. market place (no foreign market place even replaces California), they will buy treasuries.

They have dollars and need to put them somewhere. They also need to manage their currencies to keep exchange rates favorable. They need the U.S. at least as much as the U.S. needs them.


On Sep 25 11:17 AM chap08 wrote:

> "What do foreign central banks know which would encourage them to
> continue to purchase large quantities of U.S. treasuries at historically
> low yields in the face of a strong stock market? The answer is that
> indirect bidders may buy treasuries, but they do not buy the V-shaped
> recovery argument."
>
> Sorry, this is the argument I just don't buy. I've recently swapped
> foreign stocks for treasuries in reasonable scale, as a hedge. But
> longer term, they're just a bad investment. They are propped up by
> foreign central banks - not for any of the reasons you discuss -
> but simply because of their trade policies. They need to do it for
> the sake of their domestic economies. It's nothing to do with a view
> on the recovery. Without support from foreign governments, the dollar
> would fall hard and yields would jump. This won't be happening any
> time soon, but I don't want to be around when it does.

Sep 27 08:18 PM

[Bernard Thomas:]

I am not saying treasury yields are never going to rise. I am saying that for now, due to economic conditions, foreign investors have little choice to buy treasuries. They don't want to, but they have no choice. The own dollars, the need to keep exchange rates in their favor and no other country can give you the risk free liquidity as the U.S.


On Sep 26 04:08 PM TxTim wrote:

> Bernard
>
> I think you're a smart guy but I didn't read anything that acknowledges
> unprecedented Fed QE, unprecedented trade deficits over the last
> several years, and a staggering level of US Gov't debt on the backdrop
> of a proposed healthcare plan with an incomprehensible cost. Maybe
> not now but at some point investors will begin to evaluate what "risk
> free" really means. At this point in time it's beginning to look
> more and more like nothing more than the ability to PRINT money,
> not the ability to REPAY money with balanced budgets and taxes. The
> gov't is on the playing field and is distorting the market you are
> evaluating. At some point the piper must be paid for printing money.
> Didn't Friedman say something to the effect that everywhere and always
> inflation is a monetary phenomenon. You just can't print $ 1.75 trillion
> without having some effect.

Sep 27 08:20 PM

[Bernard Thomas:]

Did I say that you should invest in treasuries? No, I said that foreign central banks are investing in treasuries. Corporate bonds had been a steal, bu the are now jus "attractive". The equity market may be heading for an optimism-driven bubble (it may already be there). I am saying is that if your portfolio appreciates at 5% of the next 10 years and the economy expands at about 2.5 % over the next 10 years, be thankful.


On Sep 27 09:46 AM Tony Daltorio wrote:

> I totally disagree with the author - I do NOT invest in bubbles and
> the Treasury market is the BIGGEST bubble I have seen in nearly 30
> years in the investment industry.
>
> And I'm not a gold bug as John Galt seems to suggest that everyone
> is who disagrees with the article.

Sep 27 08:24 PM