What's Behind The Weakness In Treasury Bonds?

Includes: IEF, TLT
by: Acting Man

A Smorgasbord of Sellers

Reuters reported on Friday that foreigners have sold some $66 billion in Treasury debt in June, with the official sectors of China and Japan the main culprits:

“China and Japan led an exodus from U.S. Treasuries in June after the first signals the U.S. central bank was preparing to wind back its stimulus, with data showing they accounted for almost all of a record $40.8 billion of net foreign selling of Treasuries.

The sales were part of $66.9 billion of net sales by foreigners of long-term U.S. securities in June, a fifth straight month of outflows and the largest since August 2007, U.S. Treasury Department data showed on Thursday.

China, the largest foreign creditor, reduced its Treasury holdings to $1.2758 trillion, and Japan trimmed its holdings for a third straight month to $1.0834 trillion. Combined, they accounted for about $40 billion in net Treasury outflows.

Comments from Federal Reserve Chairman Ben Bernanke on May 22 that the central bank could reduce its four-year asset buying or quantitative easing (QE) program by September fueled a sell-off in U.S. Treasuries.

"China's net selling of U.S. Treasury could be a reaction to the possible QE exit," said a senior economist at the Chinese Academy of Social Sciences (CASS), a top government think-tank. Speaking on condition of anonymity, he said China's currency reserves management had become much more pro-active.

"Holding too much U.S. debt is not wise at a time when Treasury yields rise and prices fall. On the other hand, the adjustment has been marginal considering China's massive holdings of U.S. debt, and China cannot dump U.S. debt, which could spook markets and upset the U.S. government," he said.

But Bank of Thailand Deputy Governor Pongpen Ruengvirayudh said the decision to reduce Treasury holdings was not a new one taken in light of the Fed's tapering expectations. "We have adjusted (our strategy on the U.S. Treasury in the foreign reserves) for a while," she told reporters.


"The sell-off in Treasuries and Bernanke's tapering remarks are related," said Michael Woolfolk, global market strategist at BNY Mellon in New York. "Lightning doesn't strike in the same place twice, but Bernanke repeated his comments in June and that roiled the market."

(emphasis added)

This article's conclusion is almost certainly wrong. The numbers are certainly correct, but the assumption that the selling has anything to do with the Fed planning to slow down its inflationary policy is absurd.

First of all, the amount of foreign selling is really quite small compared to the size of the market, although it is undoubtedly the case that what used to be a tailwind has become a headwind. So why are the Treasury debt holdings of Asian nations declining? The main reasons are their declining trade and current account surpluses, which appear to be reversing the previous need for dollar recycling. This is also reflected in a declining U.S. trade deficit. Although a smaller trade deficit has a positive effect on GDP, in terms of the U.S. economy it is mainly an indication that consumer spending is weakening. That in turn is happening because real incomes are stagnating/declining, while credit growth ex student debt is weakening as well. In other words, consumers have yet to readopt their bubble habits of yore. That may not happen for a while.

As to "tapering" of "QE", it should be remembered that Treasury bond yields rose during both "QE1" and "QE2". They didn't rise "in spite" of the Fed's buying, but because of it. When the central bank engages in inflationary policy, inflation expectations tend to increase, and inflation expectations are a far more powerful driver of bond prices than any single buyer will ever be.

However, things have changed with the adoption of "QE to infinity". Let U.S. first look at another big seller:

“As the bond market plunged in late June, Ray Dalio convened the clients of Bridgewater Associates LP, the world’s largest hedge-fund manager, to tell them that a fund designed to withstand a broad range of market scenarios was too vulnerable to changes in interest rates.

Bridgewater, citing months of study, said it had underestimated the interest-rate sensitivity of various assets in its All Weather fund and was taking steps to mitigate the risk, according to clients who listened to or read a transcript of the June 24 call. By the end of the month, the Westport, Connecticut-based firm had sold off enough Treasuries and inflation-linked bonds to help reduce the fund’s most rate-sensitive assets by $37 billion, according to fund documents and data provided by investors.”

The move, disclosed to investors five days after the Federal Reserve said it’s prepared to phase out its unprecedented bond purchases, was unusual for the fund. As its name suggests, All Weather is designed to produce returns in most economic environments and avoid altering asset allocations when the outlook changes. All Weather incurred a second-quarter loss of 8.4 percent that was primarily tied to its $56 billion portfolio of inflation-linked debt, said the clients, who asked not to be named because the fund is private.

(emphasis added)

Apparently the "All Weather" fund was prepared for every conceivable market event, except the one that actually occurred. What happened was that bond prices fell in spite of declining inflation expectations. The inflation-indexed bonds were presumably intended as a hedge in the event of rising inflation expectations lowering prices of fixed rate bonds and vice versa. It appears to U.S. that market-based measures of inflation expectations may actually have been distorted. After all, these expectations are themselves measured by comparing the yields of TIPs to those of fixed rate bonds. If bond prices move primarily for market structural reasons, the "signal" may well be smothered by the "noise". One must therefore consider the possibility that inflation expectations (meaning: expectations regarding the future trend of CPI) are actually higher than indicated by these markets.

The Likely Culprit: Leverage

It is worth noting here that just a single hedge fund has sold almost as many bonds as Japan and China combined. As we already opined in a previous missive, when yields are low and the central bank appears to have everyone's back, the temptation to leverage bond portfolios is great, especially as margin requirements for Treasury securities are extremely low. The selling in bonds has started around the time when JGB volatility began to spike, but hasn't abated when JGB volatility subsequently fell again.

The suspicion must therefore be that there was or still is a lot of leverage in the market and many players remain under pressure. Consider a chart of TLT, an ETF that holds bonds with a remaining maturity of 20 years or more. The chart is a mirror image of yields. Note the correction period circled in red – this type of "running correction" indicates extreme weakness – the rebound is downward sloping, making lower highs and lower lows. This shows that sellers are impatient and are using even small bounces to renew their selling.

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TLT takes a bath.

Weakness is also evident in a very short term chart of the September t-note futures contract (a 30 minute chart showing the action over the past week is below). Even in the short term, a persistent pattern of lower highs and lower lows is still prevalent:

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September ten year t-note future, 30 minute chart.

Sentiment and Positioning

Sentiment and positioning are in large part a function of prices, and as one might expect, the sizable decline in bond prices has turned market participants very bearish and has resulted in speculators piling into short positions in the futures market.

Normally one would expect a bounce of some significance to begin fairly soon in the face of such data. However, there is an important caveat to this: as we have seen in several markets over the past year or so (such as the stock market, gold and the yen), markets are these days more likely to fail to react to such data points than in the past.

Trends tend to be quite persistent, often in spite of sentiment extremes that have previously almost "guaranteed" trend reversals. It will be interesting to see if the recent sentiment and positioning extremes recorded in the bond market will soon lead to a bounce. As can be seen from the charts below, whenever they have reached current levels in the past, they have invariably coincided with short to medium term lows. A failure to bounce would therefore be quite meaningful.

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The Consensus Inc. bullish consensus percentage has declined into the "support zone".

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Small speculators hold the largest net short position since 2005, large traders are more circumspect, but may add to their selling in view of technical weakness.

The potential problem is that the bond market is quite large, so negative sentiment and large speculative short positions in futures may not suffice to halt the decline, especially if further deleveraging is in the offing (it is of course not knowable how much forced selling has already occurred).

The Danger

To some extent the markets can no doubt adapt to rising interest rates, however the notional amounts of interest rate derivatives outstanding have grown to immense proportions over the past 30 years while yields declined. A lot of risk has been redistributed, and it is difficult to tell how capable some of those that have taken on interest rate risk are to withstand growing losses. Note that derivatives on the whole cannot lower systemic risk, they can merely shift it around. One must suspect that a great many undercapitalized players have become active in these markets as time went on and interest rates went lower. We wonder what will happen if the long term trend in rates actually changes. Not only will systemic risk presumably rise, but already overindebted governments will be forced to commit ever larger portions of their revenues to debt service. Note also that overvalued equity markets can only withstand rising rates up to a point.

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