The number of articles I've come across in recent years discussing a bubble in Treasuries (TLT) that is supposedly on the verge of popping are too numerous to count. While investors should certainly be on guard for the possibility of a sell-off in any asset they own, it's important to differentiate between a seasonal or cyclical sell-off and that of a bubble bursting.
Conventional wisdom tells us that bubbles typically burst at points at which "everyone" is bullish and "everyone" seems to own the asset. I put everyone in quotations because, of course, 100% of investors need not own the asset at the top of a financial bubble. However, typically the bullishness is so widespread that lots of investors are long.
In the recent Spring 2012 Barron's Big Money Poll, just 2% of portfolio managers responded that they were bullish Treasuries (IEF). On the other hand, 81% were bearish and 17% were neutral on the outlook for Treasuries. I can't remember the last time investors were screaming about a bubble in an asset with only 2% bulls.
What about the idea that ownership of the asset in a bubble seems to be near an unsustainable high just before the bubble bursts? Does this jibe with the current situation in Treasuries? According to the Census Bureau's The 2012 Statistical Abstract, "Equities, Corporate Bonds, and Treasury Securities - Holdings and Net Purchases, by Type of Investor," household ownership of Treasuries, as a percentage of outstanding Treasuries, dropped from 32.49% in 1957 to just 3.91% in 2008. By 2010, the latest data provided by the Census Bureau, household ownership of Treasuries jumped to 11.52%. As an aside, this number includes owning savings bonds. Excluding savings bonds, household ownership was still only in the upper single digits as of 2010.
I wish the 2011 data was already available, but given the amount the outstanding stock of Treasury securities increased last year due to the massive government deficit, it's hard to believe households could have bought enough Treasuries to increase the 11.52% ownership to anywhere near levels typically associated with retail ownership at the top of financial bubbles.
Below is a chart detailing the household ownership of Treasury securities since 1952 (data provided by Census Bureau, chart by The Financial Lexicon):
So we have 2% bullishness among money managers and household ownership of Treasuries hovering in the low double digits. Yet Treasuries are supposedly in a bubble? Ultimately, I'm less interested in the words we use to describe a particular market versus trying to figure out its future direction. However, if you are interested in arguing whether an asset class is in a bubble or not, keep in mind that just because you don't find value in a particular financial asset doesn't mean it's in a bubble.
When thinking about the future direction of Treasury prices, I am certainly cognizant of the magnitude of the U.S. government's deficits and the massive future liabilities of the U.S. government speeding toward us each and every day. I'm also aware of the fact that currently, real yields on a large part of the Treasury curve are negative. But, I'm also aware of the following:
1. Regarding Treasuries, the investing community is about as bearish as it can get on an asset class.
2. Household ownership of Treasuries is nowhere near levels that would make me fear extreme selling pressure from this part of the investing community.
3. The federal government has shown no ability to bring the deficit under control, and rising rates could put extreme immediate stress on government coffers.
4. The U.S. government is very, very powerful and can do pretty much whatever it wants.
5. The Federal Reserve has shown a willingness to monetize the debt in recent years and could, if it so chooses, buy up every single Treasury for sale in the secondary market.
6. There is more dollar denominated debt outstanding around the world than there are dollars available to pay it off. Also, when financial markets go through times of stress, we seem to discover that there isn't enough acceptable collateral worldwide for the amount of dollar denominated debt outstanding. This helps explain the so-called "flight to safety" bid underneath Treasuries, which I contend isn't really a flight to safety but rather a scramble for collateral.
While I am in no way interested in purchasing Treasuries at current yields, I think it's important to recognize that if you think through the six points mentioned above, there is a case to be made that yields will only go higher if the Federal Reserve and/or the U.S. government allow them to go higher. Of course, stating this opens the debate about how much power the Fed or the U.S. government can have over financial markets. I would argue they can have a lot and that if push comes to shove, the government would choose to protect the Treasury market at the expense of the stock market.
For now, instead of flooding the financial press with articles about a "Treasury bubble" popping every time the long bond goes up 30 or 40 basis points, it might be more useful for commentators to at least wait for the long bond to break its multi-decade downtrend in yield. Another good technical indicator to watch, which might make commentators look a bit wiser when calling the popping of a Treasury bubble, would be the long-bond's quadruple top in yield formed in 2008, 2009, 2010, and 2011. Perhaps if/when yields finally break through that level, articles discussing the popping of a Treasury bubble would be more warranted. And third, before calling the popping of a bubble, waiting to see where the long-bond ends up during the next bear market in equities might be useful. There is a case to be made that the next equity bear market will bring with it a roughly 2% long-bond.
As you will notice in the disclosure at the bottom of this article, I am long Treasuries. I was fortunate enough to have bought the double top, triple top, and quadruple top in yields in 2009, 2010, and 2011 and now have substantial long-term unrealized capital gains. I'm guessing there are others in a similar position. At current yields, I am not interested in adding to the position, and I would like to note that over time, I am interested in liquidating the position as other opportunities present themselves. For anyone else in a similar position, I'd like to share this thought:
Do not fear rising rates. If yields rise, thereby reducing your unrealized gains, you will have the opportunity to roll your position into even higher yielding, high-quality corporate bonds. I would gladly give up the unrealized capital gains on a long-term Treasury for the chance to own, under par, a whole host of individual investment grade corporate bonds (LQD) that are currently, in my opinion, overpriced. Moreover, should you still own your Treasuries during the next massive pullback in stocks, do not fear selling part or maybe even all of your position for a chance to own the S&P 500 (SPY) at lower prices. Even if the S&P 500's yield is still a couple percentage points lower than your Treasury's taxable equivalent yield (interest exempt from state and local income taxes), as long as you're buying at prices that provide a reasonable chance at enough upside over time to offset the difference in yield, it may be worth a shot.
Furthermore, until we do get a substantial move higher in rates or a massive move lower in the major stock indices, don't forget to keep an eye out for opportunities to book profits on your Treasury position a little at a time. This could be done by rolling the funds into high-quality individual stocks or even certain high-yield corporate bonds (HYG) that you find at attractive prices.
In closing, consider spending some time thinking about why it is that Treasury yields are so low. Think about what might realistically cause a sustained spike in yields and the effects that will have on the U.S. economy and the stock market. Given the role Treasuries play in international financial markets, if I were arguing for a bubble based on where Treasury yields are today, I'd spend more time focusing on a bubble in terms of the debt-financed standard of living millions of people worldwide have come to know.
If Treasuries are the benchmark against which other types of debt trade and Treasury yields go to the heights predicted by many Treasury bears any time soon, the standard of living people in the United States have come to know will, on the whole, collapse. This isn't the 1980s anymore when people could actually put decent down payments on a home and afford double-digit interest rate mortgages. This is 2012, when more than 40 million people rely on the U.S. government's ability to finance itself to put food in their mouths. This is 2012, when the U.S. economy can't even create enough moderately paying jobs for many recent college graduates to be able to pay off their student debt and still live what is considered a "middle income" lifestyle. And finally, this is 2012, when thousands of baby boomers are turning 65 every day and approaching the time in their lives when they will rely on the government's ability to issue seemingly ever-growing amounts of debt at ultra-low rates.
With all that in mind, do you think the U.S. government won't actively work to prevent interest rates from going to the levels Treasury bears often state (high single-digits to double-digits)? Do you doubt the U.S. government's wherewithal to do whatever it takes to make sure the Treasury market doesn't turn into Greece's bond market?
I have no doubt the Fed will one day attempt to flex its muscles and raise interest rates. And I'm sure the Treasury market, especially on the long end, will overreact to the initial interest rate rise and price in far more hikes than the Fed will ever be able to manage should it hike before a massive restructuring of the foundation of the U.S. economy ever takes place. I wish the Fed would hike rates. As a bond investor, I want higher yields than we have today. But I'm not holding my breath waiting for the day the long bond strongly breaks out above its 2008 to 2011 quadruple top in yields (bottom in price), let alone its 2007 high yield of roughly 5.30%. Why do I have a funny feeling that by the time those breakouts occur, Treasury investors who bought any of those tops in yield will have ridden their way so far down the yield curve that they'll be more focused on what the 10-year note is doing, rather than the 30-year bond?
Additional note: If you are curious what I mean by riding the yield curve, consider reading an article I wrote in January, "Trading the Yield Curve."
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am long Treasuries. I am long precious metals. I am long certain individual stocks. I am long certain individual corporate bonds, both investment grade and high-yield.