Treasury Bonds: Here Comes the Bull Market Flattener

In my last article entitle 30y US bond yield sends encouraging signal dated September 11, I wrote: "Should they overcome this 4.10-4.20% area, then that would be a significant long-term bullish signal for the entire UST market!" On Friday, the US TBond yield has indeed closed below this area at 4.09%! In turn, I see my bond-bullish picture confirmed and reiterate my tactic as well as strategic stance as yields should drop amid a flatter curve.

30y US TBond yield finally broke through 4.10-4.20% support area

Source: Bloomberg

To repeat, I think the US 30y TBond holds the key for the entire US Government bond market as a) it is the least distorted maturity sector and b) given its maturity it incorporates the long-term expectations for growth, inflation and the related risk premia. It is the least distorted part of the US curve as Asian central banks are reported to be most active in the shorter US Treasury notes as well as in TBills, shunning the ultra-long segment. Furthermore, the buying programme of the US Federal Reserve has also not seen large volumes being purchased in the 10-30 year area with USD21bn in the 10-17y area and USD17bn in 17-30y. As of September 23, the Fed has purchased USD289bn out of the planned USD300bn, so the programme is almost finished. Therefore, this should not have affected ultra-long yields significantly.

Furthermore, given the long term nature of 30y US Bonds, its trading behaviour should provide insights about long-term prospects for the US economy and its institutions. Amid the high economic uncertainty, ongoing inflation fears, increasing supply pressures and waning credibility of US institutions and the USD as the major reserve currency one should expect that 30y US bonds should fare badly. However, as I have shown in my post on 30y US TBond yields cited above, this is not the case at all. The combination of being the least distorted part of the curve as well as providing information about the long-term expectations and risk premia is the reason why I regard the bullish technical signal being emitted by the US 30y Bonds as so important for the entire government bond universe.

In the Eurozone, 10y Bund futures have followed the 30y US lead and made a new high on Monday morning at 121.91, breaking above the double-top reached on September 2 (121.73) and September 11 (121.74), thereby as well providing a positive technical signal.

Bund future breaks through double-top formed in early September

Source: Tradesignalonline.com, ResearchAhead

In yield terms, I maintain my initial target of a 3% level for both, 10y UST and 10y Bund yields, which I first mentioned in my blog at the start of June. I expect these levels to be reached over the next weeks, i.e. on a tactical horizon. On a stratetgic horizon of 3-6m, we might see even lower yields ahead. My longer-term structural view remains for a prolonged period of ultra-low nominal yields in line with a prolonged period of low nominal growth rates amid very low inflation rates and only limited real growth on average.

Finally, this bullish momentum should be accompanied by flatter yield curves, i.e. it will be the long areas of the curve which drive the bond market and not the short-term parts. Usually, yield curves bull-steepen and bear-flatten. This is because short-end yields are more volatile than their longer-term counterparts given that in a normal environment central banks conduct monetary policy via changes in short-term rates and because short-term expectations are more volatile than long-term expectations incorporated into long maturity bonds.

However, short-end rates cannot fall much further, leaving only limited performance potential for short-term bonds. Furthermore, central banks have been engaging in non-standard monetary policy action (i.e. QE and credit easing). The Japanese experience has shown that in such an environment of very low short-end yields, it becomes the long-end which is driving the yield curve as the volatility in short-end yields drops once they approach the 0% lower nominal bound. As the chart below suggests, the 1% level in 2y benchmark bonds seems to be where this fundamental shift in the behaviour of the yield curve takes place.

Japan: fundamental shift in the yield curve behaviour around 1% in 2y yields

Source: Bloomberg, Research Ahead

In turn, with 2y UST yields trading slightly below 1% and 2y Schatz yields at 1.20%, we should be looking for the yield-curve to bull-flatten in the weeks ahead. Therefore, I recommend long-term bonds (i.e. 10-30y) not only from a duration point of view but also in curve flattening positions relative to the 2-5y area.

Yield curves are likely bull-flattening from their extremely steep levels

Source: Bloomberg, ResearchAhead

Overall, the fundamental outlook for US and Eurozone government bonds remains supportive amid a prolonged period of low nominal growth with inflation pressures weakening further and the current real growth improvement unlikely to be self-sustaining. Technically, the US 30y TBond is sending a strongly bullish signal and also the Bund future is providing an optimistic picture. With a structural shift in the behaviour of the yield curve, we should look for a bull-flattening of the government bond yield curves in the weeks ahead.

Comments

[chap08:]

Tbonds: the ultimate bubble.

Sep 29 10:08 AM

[djackson:]

No comment on your bull flattener, but your perspective on the purity of the 30 yr is intriguing. You feel it incorporates long term outlooks. Given economists and others seem to have great difficulty forecasting even a year or two out, one can presumably say the same for 10 yrs and maybe even shorter. As for your statements about distorting forces, yes/no. I will grant that the further in the curve you come, the more intrusive the government policies for setting levels becomes. But you don't need to move all the way to 30 yrs to avoid these. What it really comes down to if you believe the bull flattener case is how much duration do you want. That determines you risk reward profile. If you are into your beliefs, I presume you are buying 30 yr strips.

Sep 29 11:39 AM

[Mad Hedge F...:]

ond Reviewing the current political and monetary landscape, I would beremiss, irresponsible, even negligent, if I didn’t revisit one of myfavorite ETF’s, the Proshares Ultra Short Treasury Trust (TBT). This isthe 200% leveraged bet that long Treasury bonds, the world’s mostovervalued asset, are going to go down. While the Fed is going to keepshort rates low for the indefinite future, it has absolutely no directcontrol over long rates. The only political certainty we can count onis the continued exponential growth in the supply of government bondsof all maturities. Like all Ponzi schemes, their eventual collapse isjust a matter of time. It’s simply a question of how many greater foolsare out there (sorry China). Look at how they are trading now. Wecurrently have the greatest liquidity driven market of all time, andthe ten year is only eking out a 3.40% yield, pricing in near zeroinflationary expectations. The average yield on this paper for the lastten years is 6.20%, a double from the current level. Get the yield backup to 5%, a distinct possibility in 2010, and that takes the TBT fromthe current $45 to $70. Sure, we may get a sideways grind in yields fora few months, which will be expensive due to the mathematicidiosyncrasies of the 2X ETFS. But a security that is unchanged if I amwrong, and doubles if I am right is the kind of risk/reward ratio thatI will take all day. And I believe that in my lifetime Treasuries maylose their vaunted triple “A” rating and be priced closer to subprime(warning: I am old). That could enable the TBT to deliver the holygrail of trades, your proverbial ten bagger.

Sep 29 12:00 PM

[Daniel Pfae...:]

Agreed, economists aren't great forecasters. What I find interesting though is that the longest part of the curve where there is the least buying activity by the Fed itself (and the programme has almost been completed by now) and where the supply fears as well as long-run inflation fears should hit the hardest is technically sending a bullish signal (which has now been followed by 10y USTs which just yesterday closed below the double-bottom in yields around 3.305% formed on July 10 and September 2). This technical situation is at least supportive of my belief that we are headed for a prolonged period of low nominal growth.
I agree with the 30y strips proposition as that provides one with even more duration. Just one caveat: I am not an expert on the UST strips market but my experience with trading German strips suggests that liquidity that far out the curve is suboptimal even in principal strips.

On Sep 29 11:39 AM djackson wrote:

> No comment on your bull flattener, but your perspective on the purity
> of the 30 yr is intriguing. You feel it incorporates long term outlooks.
> Given economists and others seem to have great difficulty forecasting
> even a year or two out, one can presumably say the same for 10 yrs
> and maybe even shorter. As for your statements about distorting
> forces, yes/no. I will grant that the further in the curve you come,
> the more intrusive the government policies for setting levels becomes.
> But you don't need to move all the way to 30 yrs to avoid these.
> What it really comes down to if you believe the bull flattener case
> is how much duration do you want. That determines you risk reward
> profile. If you are into your beliefs, I presume you are buying
> 30 yr strips.

Sep 29 12:07 PM

[Daniel Pfae...:]

Thanks for the comment. I believe that it will take a long time before any meangingful inflationary pressures are developing. We still have too many goods and not too much money. Yes the Fed has been increasing its balance sheet by an incredible amount but that money is not being lent out by banks and credit creation remains weak. I am convinced that it is long-run nominal growth which matters for long-run yields and here my outlook is for a period of limited real growth (amid a lower trend growth rate) and of limited inflation. In turn nominal growth will be significantly below what we were used to in the past and with that nominal yields can also be lower for a prolonged period of time.
"The only political certainty we can count onis the continued exponential growth in the supply of government bondsof all maturities." Agreed. Supply of government bonds will remain high for a long time as well. The question is though what happens to demand. I think that in an environment where households restore their balance sheets via a higher savings ratio, the demand for government bonds rises. Furthermore, we are likely to see pension funds holding a lower strategic share of equities in their portfolio as their risk-taking capabilities have been diminishing. Finally, banks (which dont lend) are likely to increasingly play the carry trade which also incorporates getting funds from the Fed for almost free and investing that along the curve.


On Sep 29 12:00 PM Mad Hedge Fund Trader wrote:

> ond Reviewing the current political and monetary landscape, I would
> beremiss, irresponsible, even negligent, if I didn’t revisit one
> of myfavorite ETF’s, the Proshares Ultra Short Treasury Trust (seekingalpha.com/symbo...).
> This isthe 200% leveraged bet that long Treasury bonds, the world’s
> mostovervalued asset, are going to go down. While the Fed is going
> to keepshort rates low for the indefinite future, it has absolutely
> no directcontrol over long rates. The only political certainty we
> can count onis the continued exponential growth in the supply of
> government bondsof all maturities. Like all Ponzi schemes, their
> eventual collapse isjust a matter of time. It’s simply a question
> of how many greater foolsare out there (sorry China). Look at how
> they are trading now. Wecurrently have the greatest liquidity driven
> market of all time, andthe ten year is only eking out a 3.40% yield,
> pricing in near zeroinflationary expectations. The average yield
> on this paper for the lastten years is 6.20%, a double from the current
> level. Get the yield backup to 5%, a distinct possibility in 2010,
> and that takes the TBT fromthe current $45 to $70. Sure, we may get
> a sideways grind in yields fora few months, which will be expensive
> due to the mathematicidiosyncrasies of the 2X ETFS. But a security
> that is unchanged if I amwrong, and doubles if I am right is the
> kind of risk/reward ratio thatI will take all day. And I believe
> that in my lifetime Treasuries maylose their vaunted triple “A” rating
> and be priced closer to subprime(warning: I am old). That could enable
> the TBT to deliver the holygrail of trades, your proverbial ten bagger.

Sep 29 12:16 PM

[The Geoffster:]

I don't understand the long bond at @4%. It's pricing in deflation. The FED has already been monetizing and will have to continue to service all the new debt. I'm beginning to think there will be a tax revolt or worse in response to this insanity. That's another way to repudiate debt.

Sep 29 05:33 PM

[Denis Gould:]

When something in markets is obvious, it's usually wrong. It feels like this with Treasuries. Yields can obviously only go higher from here for the reasons given by Mad Hedge Fund Trader (is he angry?). But wait. If you have the choice of earning nothing on cash or 2,3,4% down the yield curve you might initially sit with cash. But after a while of steady or falling bond yields you get fed up with no return and start to creep down the curve. As pointed out a virtually risk free way for a bank to repair its balance sheet is to borrow at zero at invest at a higher yield. And for institutional bond investors being short duration is a static market is very expensive, and vice versa. So eventually money ripples all the way down the curve.

It feels the bull story for bonds is becoming a bit popular at the moment and a setback may be afoot, but longer term yields will go a lot lower.

Finally, is there no way to stop certain people posting the same cretinous comment on every single story?

Sep 29 10:34 PM

[100%:]

> Yes the Fed has been increasing its balance sheet by an
> incredible amount but that money is not being lent out by
> banks and credit creation remains weak.

I don't think this is the main problem at all. We are all paying for the legacy assets in bank balance sheets through printed money. Again, we are buying the legacy, i.e., mostly worthless, assets through printing. That is the money that will have inflationary pressure even if Fed returned everyting else home without cost.

Buying the 10-year at 3% is one of the riskiest things one can do in this market. I doubt you will get the opportunity but I wish you best of luck with it. In any case, you have mentioned nothing but wild conjectures. This article is not even mildy serious investment advice, yes, even in SA.

Sep 30 12:04 AM

[popey:]

The long bond will collapse in the near future. Sure, you can trade bubble rallies. But ultimately, this paper is BS.

Sep 30 10:56 AM

[Aquater:]

The article is written with sharp thinking and penetrating insight. The argument for inflation is trite, obvious and overdone. In that view, this analysis is refreshing. In the least, it provides a foil for the established rut of thinking about long term bonds and the movement of interest rates over the long run.

Sep 30 12:22 PM

[realold:]

Low inflation expectations seem based upon U.S. economics only. If the emerging market economies, including BRIC countries, begin to grow on their own, commodities will continue to get scarce. Combined with massive consolidation of commodity ownership (corporations), the U.S. citizen may be faced with prolonged stagflation and a plummeting standard of living as we cannot afford to buy anything. Local services will be cheap, but the materials and finished products "serviced" will be expensive. I think that your analysis is interesting, but short-term and too U.S. centric (sic).

Sep 30 11:05 PM

[TxTim:]

Yes but how can we not have inflation? To buy the 4% 30 year bond story we have throw out nearly all the basic tenants of nearly every school of economics. I believe the Feds QE is distorting what you are seeing in the markets. Can they do it with impunity indefinitely? If so, the Fed should have been printing lots of money a long time ago and buying lots government securities.


On Sep 30 12:22 PM Aquater wrote:

> The article is written with sharp thinking and penetrating insight.
> The argument for inflation is trite, obvious and overdone. In that
> view, this analysis is refreshing. In the least, it provides a foil
> for the established rut of thinking about long term bonds and the
> movement of interest rates over the long run.

Oct 01 05:01 PM

[The Retired...:]

O.K. we all see the long bond as a bomb waiting to destroy itself. For the moment other nations are buying it in desperation hoping it will keep business and jobs afloat. Everyone knows this is a temporary fix for a problem that no one preceved far enough in advance to make proper changes.
Guys & Girls we all know we have a U.S.A, problem.
We have children in College that hate the foreigners because they work so hard our kids most of them resent the foreigners.
Our Joe public hasn't saved in 35 years big deal he's scared poop now so he's saving a few lousy dollars. Get off this Govt. B/S that savings rates are getting better it's like trying to stockpile food after a atomic attack duh duh.
O.K. forget older people going to live with their kids this is malarkey.
Our so called kids 25 to 45 yrs old,are going to be doing more of the same leaching off mom and dad. Generation (WiDE-SCREEN) as in T.V.for their priorities every toy in creation.
Back to L.T. Bonds it's retired people that have saved the supply of money that the Govt, used via L.T.Bonds to keep the services going.
Well these low rates make insolvent banks make money but they can't lend enough and collect the payments to keep the game above water.
People are not spending except prior to (Back to School) call me "Rodney Dangerfield'
If you don't give retired people enough interest to live on with the eventual inflation who is going to bail them out? We must have a guaranteed rate of 6 percent on 30 year T.bonds. With a tips C.O.L.A. so if we see 1980ish inflation the rates go up to reduce inflation and keep retired people with enough money to live.
I'm certain that you remember that rates on notes were 16 percent and L.T.Bonds between 12,5% and i hear if you were a broker 15 % which i saw 12,5 in the paper but 15% never made it to the paper it was scurried away by the brokers and M.L. etc. long before the public ever had a chance. AU went to 855+
We must bring money back into the savings arena but real money not fiat just printed wet money not even dry yet.
Only Savors have this but they save as it is their way. Not out of temporary fear duh duh.
We must not give our money to corporate America for free by buying stocks as they will not pay dividends and increase profits we are still paying auto workers $50.00 an hour.
We must reward people that have done things right.

Oct 04 06:28 AM