Short Treasury Trade Has Room To Run

| About: iShares 20+ (TLT)

Since I first wrote about shorting 10 year Treasuries prices have fallen over 20%. And though the timing remains uncertain, this article will illustrate why Treasuries likely have a way to go to reach normalized levels of 3.8% yield.

The Historical Relationship Between Yields and Inflation
It should not come as a surprise that Treasuries offer a generally fixed spread over inflation (here I'm taking the average of the preceding 3 years of inflation), though it has fluctuated over time it has averaged about 1.4% since 1900 with the major deviations coming at times of rapidly rising or falling inflation or deflation. Also note the relationship in the post-war period has be less volatile, arguably due to the credit of central bankers' ability to keep inflation reasonably stable most of the time.

The Relationship Restated
Here's a probability density function of the same data, showing that yield on 10 years relative to the preceding 3 years of inflation tends to stay in the low single digits most years.

One Final Pivot
And here's one more look at the same data, I'll stop here, but this one makes it fairly easy to see that only 20% of the time, is the yield on 10 year Treasuries less than the average of the past 3 years of inflation.

Current Inflation and What It Means
As you can see from the data below, for the past 3 years US inflation has averaged 2.4% and coupled with the average spread on Treasuries over inflation of +1.4% a 3.8% yield would be "normal". The current 10 year yield is 2.4%.

Year Inflation Rate
2012 2.93%
2011 1.63%
2010 2.63%
Click to enlarge

The price of Treasuries could fall a further 37% (from 2.4% to 3.8% yield) to reach normalized levels. Of course, many things could impede this such - fear of deflation, further easing by the Fed or a flight to safety in the event of a global risky event. In addition, inflation could fall in coming years, and that would be another way to normalize bond yields.

Nonetheless, the balance of probabilities appears to favor a further rise in bond yields. Investors should, as always, do their own research and/or seek professional advice, but any bond investor should have their eyes open that the relationship between inflation and 10 yield US Treasuries is at a relatively low end of the historical norm. My preferred trade to take advantage of this is to short TLT.

Disclosure: I am short TLT.