Is Zero Just A Number?

 |  Includes: AGG, BND, TLT, TRSY
by: Lance Fiasconaro

When all else fails, shove it in the mattress.

Mattress moneyThat is precisely the sentiment that has driven prices of top-rated government bonds to presently overbought levels. Six perceived "safe-haven" sovereigns now have negative two-year bond yields... in nominal terms! This ironically has prompted even more speculative buying, as the uncertainty associated with yields approaching the zero bound has been lifted. What will happen when bond yields reach zero? Answer: They go negative! Investors are so concerned about getting a return of their principal that they are willing to pay strong creditors to look after their money. This is unprecedented on such a large scale and highlights the severity of the crisis we face today.

As of July 19, the 30-year U.S. Treasury-Bond (T-bond) yields a paltry 2.59 percent! If you think that's low, in Japan, the 30-year government bond yields just 1.73 percent! Does anyone really think that there will be little to no inflation for 30 years? Probably not. But market participants don't like to think, and those who do think are smart enough to know that they must consider others' lack of thought. The old Keynesian adage is applicable here: "Markets can remain irrational longer than you can remain solvent." For now, Treasuries are winning the beauty contest.

Last summer's debt ceiling debate and subsequent credit downgrade did little to stop the "freight-train" Treasury market from reaching historic levels never before seen in the history of the United States. The counterintuitive "zombie buying" that followed the Congressional drama of 2011 took many (including myself) by surprise. Investors weren't about to abandon Uncle Sam overnight, no matter who said he wasn't AAA anymore.

Trader sentiment toward T-bond futures now reflects extreme optimism, suggesting perhaps that we are nearing the end of a multi-decade run. But as the well-known Yogiism goes, "It ain't over 'til it's over." Smart money interests have unsuccessfully attempted to bet against Uncle Sam in prior years, only later to join the party at higher prices. Some underperforming stock-only mutual funds are doubling down on their bad bets by shorting the Treasury market. While I feel this is an appropriate long-term bet, adding to a losing position by increasing "beta" exposure is unlikely to goose returns.

I suspect that the real concern would arise if U.S. Treasury-Bond prices were to diverge against the dollar and decline in unison with domestic equity markets, implying fear of default. (This happened briefly during the recent financial crisis.) Such behavior would be apt to trigger panic in the global financial system as fears about the U.S. fiscal situation mount.

Whether this happens this year or 144 years from now is difficult to predict. A "doomsday scenario" is not necessary to unseat the bull market in T-bonds, however. Eventually, benchmark interest rates will rise (for whatever reason), putting an end to the secular bull market in bonds. Long-term investors can mitigate these risks by reallocating their bond positions to the safest cash and cash equivalents. More aggressive participants can choose actively managed bond funds that have the option to go short where appropriate.

Historically speaking, the bond market has been a better predictor of economic activity than the stock market, and now the bond market is forecasting a serious economic contraction. If you don't have a lifeboat handy, you might not need to panic. Ever since the Federal Reserve has been meddling with the yield curve, the Treasury market bears no resemblance to a free market, and thus its predictive abilities are now questionable at best.

Disclosure: I am long TLT.