U.S Treasuries: Heading for a Rally or an Implosion?

Historically, because the US was the #1 superpower (and the largest economy in the world), Treasuries have generally been one of the very few “risk free” investments on the planet. Consequently, Treasuries are where money runs to hide when the rest of the financial world is in trouble.

You can see this in the below chart. As soon as the financial crisis began in earnest with the credit market lockup in July 2007, 30-Year Treasuries broke above 112, a point of historical resistance. This told us two things:

1. Treasuries were still considered a safe-haven
2. The former point of upward resistance (112) was NOW the point of support (where Treasuries would bounce)

Wednesday, thanks to a Fed Chairman who’s only skill lies in hitting “print,” Treasuries may be in trouble… big trouble.

As I’m sure you’re aware, starting in July 2007 the financial markets entered one of the most severe crises in history. In response to this, the US Feds (Federal Reserve, Treasury Department, etc.) have tried to prop up the financial system with numerous interventions.

A brief recap of their moves includes:

• The Federal Reserve cuts interest rates from 5.25-0.25% (Sept ’07-today)
• The Bear Stearns deal -- Fed buys $30 billion in junk mortgages (March ’08)
• The Fed opens various lending windows to investment banks (March ’08)
• The SEC proposes banning short-selling on financial stocks (July ’08)
• The Treasury buys Fannie (FNM/Freddie (FRE) for $400 billion (Sept ’08)
• The Fed takes over AIG (AIG) for $85 billion (Sept ’08)
• The Fed doles out $25 billion for the auto makers (Sept ’08)
• The Feds’ $700 billion Troubled Assets Relief Program (TARP) (Oct ’08)
• The Fed buys commercial paper (non-bank debt) from non-financial firms (Oct ’08)
• The Fed offers $540 billion to backstop money market funds (Oct ’08)
• The Feds backs up to $280 billion of Citigroup’s (C) liabilities (Oct ’08).
• $40 billion more to AIG (Nov ’08)
• Feds agree to back up $140 billion of Bank of America’s (BAC) liabilities (Jan ’09)
• Obama’s $787 Billion Stimulus (Jan ’09)
• The Fed’s $300 billion Quantitative Easing Program (Mar ’09)
• The Fed buying $1.25 trillion in agency mortgage backed securities (Mar ’09-’10)
• The Fed buying $200 billion in agency debt (Mar ’09-’10)
• Cash for Clunkers I & II (July-August ’09)

And that’s a brief recap (I’m sure I left something out).

Now, you can’t throw trillions of dollars around without damaging your country’s balance sheet (especially when the country already owed $9 trillion to begin with). So it’s no surprise that our creditors (China and Japan being the two largest) aren’t too pleased about the Feds' profligate spending. As a consequence, they’ve all but stopped buying US debt (Treasuries).

Indeed, between 1Q09 and 2Q09, foreign holders of US debt reduced their purchases from $159 billion in 1Q09 to $101 billion in 2Q09 (a 40% decrease). If it weren’t for the Fed’s own purchases of Treasuries ($164 billion out of $339 billion), the US Treasury market would have almost assuredly had numerous failed auctions in the last six months.

In simple terms, China and Japan have made it clear in no uncertain terms that they want higher yields before they start buying US debt again. And in order for yields to go higher, Treasuries have to fall hard.

The warning signs are already there.

When the Fed first announced its Quantitative Easing Program in March ’09, Treasuries began a steep decline. They then bottomed out in June and have since begun moving in a well-defined trading range:

Remember, the Fed bought $164 billion worth of Treasuries between March ’09 and June ’09. And Treasuries still collapsed during that time. Looking at the above chart, one can only imagine what kind of collapse would have occurred if this support hadn’t been there.

With the Fed’s QE Program ending this week and Treasuries already moving rapidly toward the lower part of their trading range, it looks like we’re about to discover what the world really thinks of US debt as an asset class.

Thus we are at a point of major historical significance. It is now literally a question of which crisis is next. Something has to give. And it could be either stocks, bonds, or both.

I, and the rest of the financial world for that matter, do not know which of these will unfold. However, it’s quite possible we’re heading for Option #3 since no one but the Fed is buying Treasuries in any large amount.

Indeed, QE is about to end and Treasuries are already heading toward the bottom end of their trend line. And this is happening at the exact same time that the Treasury is issuing another mega-load of debt -- an astounding $180 billion this week, $116 billion of which is new debt.

• $29 Billion in 91 Day Bills, October 26
• $30 Billion in 182 Day Bills, October 26
• $7 Billion in 4.5 Year TIPS, October 26
• $44 Billion in 2 Year Notes, October 27
• $41 Billion in 5 Year Notes, October 28
• $31 Billion in 7 Year Notes, October 29

Look at the below chart again. Any decisive break below 115 on the 30-year bond leaves 105 as the next support. Below that the next major support is 90. At that point we’re getting into some really serious trouble.

Thus, the question remains…

Are Treasuries about to rally or implode?

Buckle up, cause we’re about to find out.

Comments

[Mad Hedge F...:]

I vote for implosion. 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.

Oct 28 12:28 PM

[cyclingscholar:]

I just don't like 'crisis' scenarios, they are usually just latter day jeremiads. I say a weak version of scenario one. Stocks resume their decline, perhaps to a new low; bonds and the dollar benefit from some flight capital; commodities/gold sell off sharply.

Not until the US and the world make a major commitment to free markets, free trade, lower taxes, less crony capitalism, and less regulation, the world economy will continue a Jimmy Carter scenario of stagnation. Dow PE of 6, anyone???

Oct 28 12:41 PM

[User 353732:]

1. As long as free liquidity is force fed into financial markets AND there is energy, metals, food price inflation the overall stock market cannot collapse because there will be (as there currently are) a set of privileged companies with global reach who profit greatly from the vast, free liquidity and there are the large real asset(including energy agriculture, nuclear technology) based companies with continental or multi national operations who are obvious beneficiaries of asset price inflation and flight to safety: as long as ordinary Americans still have property rights that is. Thus there can be a potent decoupling between the US Economy and the stock market INDEX
.
2. The US dollar is beginning to be viewed as a risky asset and multiple alternative proto currencies already exist. The flight from the dollar to these currencies or hard asset sectors in general may lead to a milieu where the dollar keeps compressing but certain sectors and stocks and bonds of relevant superregional or global companies do well or very well. Such proto currencies or relevant financial instruments by moving counter to the dollar create a new reference point or measure of merit for the" Lowest Risk" rate of return: nothing is ,was or really can be riskless.

3. A collapse in the incomes and savings of scores of millions of ordinary Americans while the top 1% not only insulate themselves from any crisis but profit and are seen to profit from it(as is the objective reality today in the US:it is not yet recognized as such by a majority of Americans) may lead to a revolt(violent) or revolution(peaceful and Constitutional) led by the fearful but enraged Middle class or even a civil war that is both political(secession) and physical(use of force and ensuing casualties).
Who knows what the economy looks like under these circumstances but it is worth remembering that economies and polities have, throughout history, co-existed with revolution, revolt, civil war and polity dissolution. Of course it will no longer be"The Economy" as we are accustomed to analyzing but a set of linked and nested economies, some collapsing or collapsed, others surviving and a few either vertical or geographic actually thriving.There will even be functioning markets including new types of financial, capital and equity markets as well. This has been the global experience for thousands of years and can still be witnessed in the Global South today.

Oct 28 12:55 PM

[Mistrofan:]

Implosion - but maybe is too much said like that. Let's just say gov bonds will fall.

Oct 28 01:00 PM

[Dave Wrixon:]

If you wanted me to buy Treasuries I would be looking for a yield in excess of 30%, and even then I would not sleep nights.

Oct 28 01:15 PM

[DormRoom:]

The global economic order is a farse. The top 2% in the U.S. who caused this calamity, and control access to capital, or are among the priviledge elites can always escape to another country whos economy isn't crashing around them.

If you have enough $$$, you can flee anywhere; especially since you have villas, chateaus, and lodges spanning the globe.

Nationalism is dead. There are no loyalties; only ideologies. And that is easy to pack.

Oct 28 02:19 PM

[untrusting ...:]

Good article. Your 3 crisis model seems about right to us. It does appear that ST, senario #1 is starting to play out. We think that is the most likely ST outcome which will in turn give much more room to stave off senario #2 in the ST. The government can ill afford senario #2 and thus has no choice but to let senario #1 happen, in order to shore up the massive government debt issues in the ST.

Oct 29 12:54 AM