Shorting U.S. Treasury Bonds Could Be A Widowmaker Trade

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Summary

The yield curve spread is still in a downtrend.

So, long-term rates are still expected to fall.

Wait for the yield curve trend to change before shorting Treasury bonds.

Everybody is familiar with a famous "widowmaker trade" - short Japanese bonds. If you are not, basically, many went broke shorting Japanese bonds over the years.

Now, many are predicting a great US bond bubble burst, and many are publicly admitting a short position in US Treasury bonds. But, really, what's the fundamental reason to expect the rising US yields.

Let's take a look at the spread between the yields on 10-Year Treasury bonds and the 2-Year Treasury bills in Figure 1 over the last five years.

Figure 1.

As you can see, the spread was only at 0.8% before the US elections, and in a clear downtrend. Note, at the time, we had around 1.5% yields on 10-Year T bonds. Right after the election, the spread jumped to close to 1.4%. But notice, on the chart, this simply looks like a correction in a downtrend. More importantly, the spread has narrowed after the initial spike, to 1.2%.

So, if the trend continues, we are going back towards the 0.8% level, which implies around 2.1% yields on 10-Year Treasury bond if the Fed policy does not change (which is reflected in a 2-Year bill), and then possibly lower towards 0% and further to negative territory, as the long-term rates further decrease.

So, let's look at the yields in 10-Year T bond over the last 10 years (Figure 2). Similarly, the post-election Trump bump looks like a correction in a downtrend. The yields are currently stuck at the 2.30-2.60 range, which is the resistance level in a downtrend. So, based on the trend analysis, the 2.30% level will be broken first, but let's see.

Figure 2.

The point is: The trend right now is still pointing towards lower yield curve spread, which means lower long-term interest rates. This is a fact, and when it changes, I will let you know.

Why am I looking primarily at the yield curve (Figure 1)? Here are the three scenarios:

Scenario 1: Short long-term interest rates because the Fed is behind. Within this scenario, the 10-Year yields would rise above 3%, while the 2-Year yields stay near 1.3%, so the yield curve widens. This would essentially break the almost 40-year bull market in T bonds, and start the new cycle of rising interest rates - higher high on the chart.

Scenario 2: The Fed gets more aggressive, but the long-term rates fall, similarly to the Greenspan's Conundrum episode in 2004-2005, so the yield curve narrows. Eventually, we are back to the zero interest rates environment. Here the shorts get squeezed.

Scenario 3: The Fed has already raised short-term rates too far, and the long-term rates start to fall, so the yield curve narrows. Similarly, we are eventually back to the zero rate environment, just much quicker. Here, shorts also get squeezed.

So, fundamentally, what is the justification for the higher interest rates - the Scenario 1? Faith in Trump's reflation policy? I don't see any evidence of this, except optimism-based on promise. Thus, shorting bonds based on some kind of election promise, with no concrete evidence, well, that could be a widowmaker trade.

Once there is some kind of indication of the Trump policy implementation, I bet the trends will change too, and in this case, we would actually see the 2% on the spread, and above the 3% on the 10-Year yields. So, my recommendation is to just wait for the trends to change (if they actually do) before shorting T bonds (NYSEARCA:TLT) - there will be plenty of time to trend follow.

The implications for the broader markets: stocks (NYSEARCA:SPY) are likely to have a serious correction as the long-term rates decrease and the spread narrows, but the bear market risk increases as the spread approaches 0%, based on historical evidence. The dollar is possibly past the top already (NYSEARCA:FXE) (NYSEARCA:FXY), so consider buying gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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