U.S. Long Bonds: Be Careful, We're in Injury Time

Since the advent of the credit crisis, stock markets, real estate and the U.S. dollar have been the subject of investors’ angst. However, two markets – commodities and long bonds – have remained in bullish trends. That, at least, is the way it looked until recently.

The Reuters/Jeffries CRB Index hit a peak on March 13, and I argued in a subsequent post that although a correction was overdue, the long-term trend was still upwards.

But what about the outlook for U.S. bonds, especially as yields have edged up since the recent lows of 3.314% (March 17) and 4.165% (March 20) for the 10-year and 30-year Treasury Note, respectively?

The graph below shows the long-term movement of the yield on the US 10-year Treasury Note, indicating that long-dated US bonds have experienced a multi-year bull market and are trading at levels last seen more than 40 years ago as far as nominal yields are concerned and 28 years ago in real terms. Thinking of which, the only investors who first-hand experienced the last major bear market in bonds (from 1971 to 1980) are now all on the wrong side of 50!

click to enlarge

Source: I-Net Bridge

Let’s now turn to a shorter-term graph of the 10-year Treasury Note yield in order to see the recent action.

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Source: StockCharts.com

The chart illustrates the sharp fall in the yield over the past few months as investors scrambled for safe-haven investments as the subprime fallout intensified. Although the yield has bounced off the bottom Bollinger Band (bottom green line), no sell signal as such has been given. However, the positive divergence of the Stochastic Oscillator is of some significance as it often acts as leading indicator of the yield graph. Although the 50-day moving average (off-blue line) could provide a short-term barrier, the real test will be the February high of 3.917%, which also coincides with the top Bollinger Band (top green line).

It would be remiss not to also show the weekly chart of the 30-year Treasury Note yield, and specifically to point out the triple bottom that has formed over the past five years, providing particularly strong support in the 4.15% to 4.20% area.

click to enlarge

Source: StockCharts.com

Why would long bond yields be breaking upwards (i.e. why would long bond prices be topping out) from a fundamental perspective? Bonds could be discounting better business prospects a few quarters down the line, or they could be discounting rising inflation ahead, or perhaps both. Quite a likely scenario is that we could see a continued base formation for a while longer as the forces of inflation versus deteriorating/improving economic prospects play themselves out.

Time will tell when bond yields will hit a secular low, but in the meantime one should be cognizant of the fact that an investment in a 10-Year Treasury Note will by definition lock in a total return of 3.5% over the next 10 years. This sounds unsustainable and I find it difficult to see the long-term investment merit of such an investment. Long-dated bond prices could be hit hard once yields adjust to more realistic levels.

Be careful – we’re in injury time.

• • •

P.S.: South Korea pension fund shuns U.S. debt

I have just been alerted to a very topical article that recently appeared in the Financial Times. The relevant paragraphs are republished below:

The world’s fifth-largest pension fund will no longer buy US Treasuries because yields are too low. The move signals what could be a big shift by financial institutions away from US government debt into higher-yielding assets.

South Korea’s National Pension Service, which has $220 billion in assets, said on Wednesday it wanted to broaden its range of overseas investments.

’It is difficult to buy more US Treasuries because the portion of our Treasury investment is already too big and Treasury yields have fallen a lot,’ said Kwag Dae-hwan, head of global investments at the NPS. ‘We need to diversify our portfolio away from US Treasuries and we find asset-backed securities and corporate debt more attractive because of wider credit spreads.’

A manager at the NPS’s overseas investment team said: ‘The Fed continues to cut interest rates. We are still making profits from the Treasuries that we bought in the past but we think we’d better dispose of them and had better buy higher-yielding European-government debt.’

Central banks from 16 Asian countries said last weekend at a meeting in Jakarta that they might invest more of their $1,000 billion of official reserves in one another’s sovereign bonds instead of US Treasuries, given the dollar’s volatility.

Source: Financial Times, March 26, 2008.

Comments

[granger:]

I have been watching closely. I am considering moving some of my longer term bond holdings over to Commercial Paper funds (EFR and FCO) and an inflation protected money market. It sounds insane, but I know what inflation an do to bonds. I am desiring to be in short (maybe intermediate, maybe) timeframes. I want instruments that will adjust upwards when rates do. Any thoughts or feedback. (I am also tilting my equity investments towards large cap growth to combat inlation as well)

2008 Mar 28 11:41 AM

[Myron Shlapak:]

Granger,

I have some PFN. It is an Adjustable Rate Loan fund. As short term rates are currently going down, its monthly payment is being reduced and current holders are selling. This is causing PFN to sell at a discount to NAV, it is an PIMCO/Allianz ETF.

If you believe, as I do, that the future direction of interest rates are higher than these type of funds may be the way to go.

One caveate, as rates go up marginal borrowers will go belly-up at a higher rate.

2008 Mar 29 06:26 AM

[goatfarmer:]

I'm not an expert on bond fundamentals. However, I little experience with classical technical patterns. The one I see for TIP, the inflation-based bond, is one of the most bullish long term patterns I can recall. There is a chart of TIP on the next edition of my website. Take a look on Monday or Tuesday, by which time it should be uploaded.

2008 Mar 29 09:32 AM

[Wisdom-Seeker:]

I'd be leery of applying _stock_ technical chart patterns and chart analysis to _bond_ ETFs. The factors that move Treasuries (and, for Goatfarmer, TIP) are not the same as those that move equities.

Although bond yields can't stay low forever, it's historical fact that the 10-year Treasury yield did stay very low, and I think didn't cross above 5% at all from about 1930 to about 1966). The stock market of course doesn't behave like that.

In any case, there's a significant probability of a deflationary scenario playing out (e.g. Great Depression, Japan 1990s, and plenty of other countries historically) in which case long bonds will do very well, while TIP will get crushed since the return will be exactly zero. Conversely, in an inflationary crisis, the long treasuries will get crushed (as in the 1970s) but TIP will lag since government will have strong incentives to continue to suppress the CPI readings, to avoid a medicare/social security death spiral. If you believe in inflation, equities or hard commodities could do better.

2008 Mar 29 05:10 PM