U.S. Treasury Zeroes: The Contrarian Trade Of The Century

by: Ivan Martchev

It has been over three years since the Up and Down Wall Street section in Barron’s featured a column titled “German Bunds: The Short of the Century.” While I would characterize the title as bombastic, it was not the idea of the author to title it that way. He was simply accurately explaining how Jeffrey Gundlach and Bill Gross felt at the time about German 10-year federal notes, dubbed bunds, and German 2-year federal notes, dubbed schatze notes, or by their more colorful name, bundesschatzanweisungen.

German Ten Year Notes versus German Two Year Federal Notes Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I know from experience that the forecasting business is not easy and that all forecasts are inherently wrong, since they involve moving targets – which are just a snapshot in time. Markets constantly change, so targets constantly move, making even the best forecasts far from precise. One could say that the good forecasts by definition are merely “less wrong” than the bad ones. Still, if after three years the short of the century has not worked out for bunds or bundesschatzanweisungen, then this can only be characterized as a bad forecast. The bunds closed last Friday with a yield of 0.28% and have been in negative territory (as low as -0.19%) since they were proclaimed “the short of the century.” The bundesschatzanweisungen closed on Friday with a yield of -0.66% and have been as low as -0.95% last year.

Many investors now feel that the U.S. Treasury market is a similar “short of the century.” They feel that the only way for long-term yields to go is up, due to the quantitative tightening tsunami coming from the Fed’s balance sheet. I shared such concerns early in 2018, knowing that the Fed’s balance sheet annual runoff rate was slated to be upped to $600 billion, but that was before trade war threats became big news.

To be fair, we don't have a real trade war with China yet. The Trump administration is imposing massive tariffs with a purposeful several-week delay in order to use these threats as a cattle prod to get the Chinese to the negotiating table. While this may have been a good “muscle strategy” that worked many times with the lenders of the numerous Trump Organization subsidiaries that filed for bankruptcy over the years – to get them to work out the loans for cents on the dollar – cattle-prodding the disciples of Sun Tzu in Beijing is a dubious proposition at best. The Chinese are famous for “saving face” and I am afraid they will dig in their heels and cause the Trump administration strategy to backfire, resulting in a real full-scale trade war.

United States Ten Year Government Bond Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

This is precisely why the yield curve is massively flattening at the moment, as short-term rates are going up, courtesy of Fed policy while long-term interest rates are not really moving despite the QT tsunami as investors are mulling the deflationary effects of a real trade war. One could say that 3% has become the resistance level in the 10-year Treasury yield, and that we are dangerously close to a false breakout in 10-year Treasury yields, causing all those shorts that have been placed in the U.S. Treasury market in 2018 to turn into a giant short squeeze.

One Hundred Years of the United States Ten Year Government Bond Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

From a longer-term perspective, we have broken no trend lines in the 10-year Treasury yield. While there may have been a marginal violation of the long-term downtrend that started in 1981, we have already experienced one such false breakout in 10-year Treasury yields in 2007 when the market moved above 5%, only to fall to a hair above 2% in 2008 as the Lehman Brothers catalyst made the dominoes in the U.S. financial system fall much faster than they would have otherwise fallen. A real trade war can produce the same effect in the U.S. Treasury market, causing the 10-year note yield to drop to 1% or lower due to the global deflationary implications that it would produce.

The Yuan is the Weapon of the Sun Tzu Disciples

I need to clarify a point I made in a prior column: The Chinese have a credit bubble that is now deflating, but creating a credit bubble was not the goal of the Chinese government over the past 20 years, when the Chinese economy grew from $1 trillion in GDP at the time of the Asian Crisis (1998) to the present $12 trillion, the second largest in the world. The goal of the Chinese government was to extend their economic expansion into perpetuity, which I believe is impossible to do. They tried to control the lending activities of state-owned banks and thus force-fed credit any time the economy showed signs of weakness.

Deflating Chinese Credit Bubble Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

One notable peak in the force-feeding of credit came after the failure of Lehman Brothers in 2008-09. At the time, the PBOC again re-pegged the Chinese yuan, which had been allowed to slowly appreciate before the Lehman failure. You can see that in the flattening of the yuan exchange rate for about two years until 2010, as well as the surge of yuan loan growth after the Lehman failure.

Unfortunately, such lending activities result in misallocation of capital and the present credit bubble, demonstrating itself in the construction of empty cities and the overall slowdown of the Chinese economy as it matures under a heavy debt load. The present overdue trade confrontation is likely to make matters quite a bit worse for the Chinese economy as a mainland recession is overdue.

I am not sure if a further yuan devaluation will fully negate the impact of the Trump tariffs, if they go into effect later in July and August, but I am sure that a massive yuan devaluation similar to the one that happened in 1993 will be a deflationary event for the global economy, at which point not even the quantitative Fed-tightening tsunami will be able to stop the 10-year Treasury yield from declining.

In the case this turns out to be a real trade war, buy U.S. Treasury zero-coupon bonds, because the 10-year yield is likely headed to 1% or lower.

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