Don't Be Too Bearish on the Bonds, Seriously

Anonymous's picture

Everybody loves to hate the bonds. “Confetti”, “certificates of confiscation”, “wall paper” are some recent terms used to describe them. I agree, it sounds like a loser's bet to give your money away to that “malfunctioning corporation called America” (Gordon Gekko, correct me if I am misquoting) for a measly 3.75% a year for 10 years. For 30 years the assumptions begin to sound even more ridiculous. But are they really? (Hint: check the 10-year return on an S&P 500 index fund, negative right?)

So why not short them?

We have a deflationary problem, which cannot be simply solved by printing. Let me elaborate. The original “printers” are not Bernanke & Co, but the Japanese, which pioneered quantitative easing in the late 1990s. From the CLSA 1Q review, which was available in the public domain earlier this year on their website for everyone to see:

Obama is sending increasingly explicit signals about the fiscal package he feels necessary to stimulate the US economy. He has also made it clear that he will not be dissuaded by a growing budget deficit. This was already US$436bn or 3.1% of GDP in the fiscal year that ended in September and as Figure 13 shows, net issuance of Treasuries exploded in September and October.

Treasury Issuance

A successful Chinese fiscal stimulus implies a fall in the current account surplus. China’s forex reserve growth is therefore likely to slow further and with it official purchases of Treasuries. Despite this we would be long duration in the US bond market; for most of 2009 we expect 10-year yields to be well below 2%. [They have changed that forecast now given the green shoots, not taking the piss--AD]

Though foreign buying of Treasuries will shrink, US savers will more than make up the gap. The US private savings-investment imbalance is swinging towards savings as households cut discretionary spending and corporate investment falls. The visible expression of this will be the collapse in loan to deposit ratios as bank deposits take a disproportionate share of newly generated savings and ultra-tight lending attitudes and debt repayment shrink loan portfolios. This is not just specific to the US; expect loan to deposit ratios to shrink across all Anglo-Saxon economies.

There are two additional factors that also suggest lower yields. First debt issued to finance the purchase of distressed assets really amounts to a debt swap. The institutions that sell problem assets to the Treasury (or Fed) will be the buyers of the government debt that is necessary to fund the purchase. Second, as we note in Question 9, Bernanke has explicitly included outright purchases of Treasuries as one of the unconventional policies that he will pursue to expand the Fed’s balance sheet. Such outright purchases in Japan contributed to an historic low of 45bp for 10-year Japanese government bonds in June 2003 (Japan’s general government deficit was around 8% of GDP at the time):

QE

The scale of Japanese outright debt purchases was not the only factor that generated sub-1% yields in Japan. The dip in yields came at the end of a long period of private sector deleveraging, sub-1% growth (in 2001 and 2002; 2003 saw GDP growth accelerate) and consumer price deflation. All are present in our US forecast for 2009 and 2010 also.

Now the Fed is winding down purchases of Treasuries, because it has averted the crisis (TBD I think). Even Roubini is praising Ben, only Nassim Taleb calls them as he sees them (h/t Nassim). Whatever you do, don't short the bonds by digging your heels in. An idiot that I worked for last year did it 5 times in a row and five times lost money. A bond short is OK for a (well-timed!) trade; the late Benet Sedacca nailed them back in December. But if you are looking for the short of the century, that one will have to wait for quite a few years, IMHO (JGBs on a longer scale presented below).

 

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Anonymous's picture

Andy, thanks for presenting the case against TBT! Faber is calling bond shorting the trade of the century...that is a long time frame! I agree, it has to be well timed, holding TBT for one century is just too long! LOL

Bam_Man's picture

FYI,

Like all double-inverse ETF's, TBT is a worthless piece of sh*t.

The tracking error is horrendous.

 

Anonymous's picture

Hi, another good post!

I think many people are ignoring the rapidly improving US household savings rate and the dwindling current account deficit.

The household savings I guess would end up in money market funds, in which then flows into longer term tresauries.

This i think is the prime reason for the persistent sub 1% yield on the JGBs as saving rates are infamously high in Japan. Only a cultural and demographic shift would change that. However, in the US i cannot see savings rate more than enough to offset the $1.0tn+ swing in the government sector. (thats a shift of 10%+ on the household savings rate!), so i think supply will overwhelm everything.

A chart of the Fed budget deficit over the last 20 yrs tells the story! the sudden plunge to -$1.5tn from -$0.4trn in the space of a few months tells the story!

Daedal's picture

Doesn't latest data indicate savings rate declined? If Mr. Black Swan is correct, and the amount of consumer debt that still exists in the system paired with growing unemployment, savings rate will have a hard time rising substantially due to overhanging debts. Higher savings rate with an overall negative equity is not sustainable especially given money market rates vs debt rates. The point is how many people can actually save? In a free market, high interest rates naturally emerge in this environment and subsequently encourage/drive savings rates higher. Artificially low interest rates will act to prevent a substantial rise in savings rate, and may even encourage further debt increases for those not currently burdened by existing debt.

TheGoodDoctor's picture

I figured if there was another downturn, that it would turn that positive savings negative again. I could be wrong though.

Bam_Man's picture

You may be forgetting that paying down loan principle counts as "savings".

There is -- and will continue to be -- plenty of that going on.

Daedal's picture

Surely, but paying down of debt is actually money being transferred over to another entity, whereas keeping it in savings capitlizes banks to lend out the money. I'm not knocking paying off debts, but surely there's a material difference between people who build up positive savings and people who decrease their debt. Both are certainly positive, but it is positive savings that create real growth, and I don't think there will be much of that until debt is actually paid off. (Which is why Mr. Black Swan & Roubini call for expedient conversion of debt into equity... the faster that happens, the faster economy will recover).

frozenfood's picture
frozenfood (not verified) Daedal Aug 14, 2009 11:54 AM

(A) the seller retains a participation of not less than 10 per centum in the mortgage; (B) for such period and under such circumstances

Anonymous's picture

"The household savings I guess would end up in money market funds, in which then flows into longer term tresauries."

Umm...no. "Household savings" is actually paying down debts, NOT saving. All the money going into "savings" is going to Visa, Mastercard, Discover, etc, NOT into money markets or even plain old savings accounts.

Anonymous's picture

Japan has to re-issue a large amount of JGBs in 2010, correct? Any thoughts on this?

TheGoodDoctor's picture

What is JGB? I keep thinking Jerry Garcia Band. LOL.

Anonymous's picture

Nice tip of the hat to Blue Steel, Andy. He nailed a lot of things over the past couple of years. I miss him much...

Anonymous's picture

The difference between Japan and the US today is that Japan had/has a large pool of domestic savings. The US is still importing $400 billion to $500 billion per year, down from the $900 billion rate a year ago.

While it is possible that foreigners keep lending us cheap money, it's not a stable bet. Also, it's possible that domestic liquidity can flow into Treasuries, but that would involve either a crowding out effect or some form of extraordinarily levered carry trade by some domestic vehicle (SIVs?). If we get a crowding out effect, it will negatively impact the economy, resulting in higher deficits as tax revenue declines.

Anonymous's picture

Americans funding treasury purchases via a carry trade? The SIV product would have to yield less than the treasury so people could short the SIV and buy USTs. What kind of loan package is risk-less enough to yield less than government debt?

Anonymous's picture

I was referring to Fed backed SIV's borrowing at zero from the Fed and buying Treasuries - levering it up to whatever. It's conjecture on my part, but it's the only way I imagine keeping a lid on long Treasuries while keeping it off the Fed's balance sheet. Any other form would result in red flags when 10Q's are released.

Steak's picture

First of all THANK YOU for putting up that Japanese 10-yr chart overlaid with their central bank rates.  I've been looking for something like that for months as the BoJ's site is quite difficult to navigate.

Just considering the deflationary forces present and coming to the fore it seems quite reasonable to bet on Treasuries.  However, what gives me constant pause is that Treasuries have been enjoying a 30 year bull market.  I'm semi-obsessed with the history of capital markets all over the world and any 30 year bull is incredibly hard to sustain. 

I see that chart of the Japanese 10-yr and what stands out is the trough yield in 2003 as you noted.  It sure looks like a trough to me.  The political context in Japan has the opposition party making noises about wanting higher yields (so older folk can actually get returns on their savings), which lends more support to the .45bps as a trough yield.

When looking at our own 10-yr the 2% yield in December sure looks liek a trough as well, or at least a bottom that will be tested in the future but not sustained.  I agree that we're not likely to see the ultimate bubble of Treasuries burst for several years, but I firmly believe we're building a base in Treasury yields that will prove to be a multi-generational low.

Anonymous's picture

so the rates are now at historical lows, the only way for them is to go up which means bonds prices will come down. Tell me again why bonds are not the short of the century/decade/year?

speculator's picture

Bonds are cash for big money players, and cash is what you need when credit dries up.

Here's a tip: prices don't have to make sense. The yield on the long bond hovered under 3% for years in the 1940s as our debt / gdp hit record highs and inflation stayed at 10% for years.That was the last top in the bond market, 65 years ago.

At the bottom, about 25-30 years ago, the long bond yielded 14% even after inflation had come down under 4% post-Volker.

Sentiment and crowd psych are 95% of trading. Take it from a guy who went long the 30 year last summer and shorted at New Year's: Bonds are a buy here.

Anonymous's picture

The FED has stated twice now that it will stop buying Treasuries in October. Unless the market is plunging, look for a short-term TBT buying opportunity leading into the October treasury auctions.

steve from virginia's picture

Treasuries have been enjoying a 30 year bull market.  I'm semi-obsessed with the history of capital markets all over the world and any 30 year bull is incredibly hard to sustain.

There is no reason why they can't have a 31 year bull market. Even 31.5 year bull ... Also, there is nothing constraining Bernanke from buying if he wants to, through proxies and PD's like he has been doing. He just SAID he wasn't going to do it ... too much:

The Fed has to buy. There is too much supply and there will be more supply. Who else is going to buy it?

The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets

I would say that 10 - 30yr are a kinda momentum trade. I wouldn't short anything right now. OUCH!

Anonymous's picture

Hi Andy,
The persistence of low interest rates in Japan is commonly provided as evidence to counter the Treasury bear case. However, it is important to note some of the significant differences between the two situations.

Japan is a net exporter; the US is a net importer. The Japanese own the majority of their sovereign debt; the US does not.

Japan is a net exporter and when the yen falls, it is actually beneficial for their economy because more people will buy Toyotas and other Japanese goods. Remember when USDJPY was at 122?? (Higher number is yen weakness) The yen was pushed extremely low and has since rebounded. Also, because of the high savings rate in Japan, the citizens and businesses own a large proportion of the outstanding JGB’s. They didn’t face losses from the weak yen since that is their local currency.

If the USD falls significantly (like the yen did) then inflation will rise because we are a net importer. I admit that our trade balance will improve, but we don’t have the manufacturing base that we used to, so there is a limit. Also, we do not own the majority of our sovereign debt. If the USD falls significantly, then China, Japan, Europe and everyone else that owns Treasuries will experience significant FX losses when they sell and convert to their local currency.

Because of these two differences, we are facing a tougher dynamic than Japan has faced. We cannot continue to buy Treasuries to keep interest rates low because of the potential consequences. I feel that our economy is in worse shape than most perceive; however, we will not have deflation due to the shortsightedness and recklessness of Bernanke and Congress. They will ensure that we will have significant inflation. There may be significant volatility on the way, but long-dated Treasury rates are going to rise considerably and the USD will be worth a fraction of what it is today (Remember, the pound was once the primary reserve currency, no longer). Japan’s experience is not an analogous model.

A Treasury Bear

Anonymous's picture

One would say, the USD being a net debtor, and USD being the reserve currency is actually the very reason why QE will have to stop at some point - regardless of whether the economy is "leveling off".

Simply put, the reason why QE is bound to fail in the US is that the feedback loop of soaring inflation expectations into higher yields, higher commodities, higher mortgage rates and pretty much a disaster for the economy - that feedback loop is so strong, that at some point debt deflation WILL look like the best option.

THis is what makes the UST market so amazing. It just can't be manipulated. Bernanke has a better chance at sending the yields lower by staying out of the market than by going on with the printing press at this stage.

- Joseph

Fazemytrade's picture
Fazemytrade (not verified) Aug 13, 2009 1:48 PM

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Anonymous's picture

I had a boss (at a primary dealer no less) who used to say, "God doesn't even know what interest rates will do next week."

And he knew what he was talking about.

Anonymous's picture

Thanks Andy, great read.

I must admit (and apologies in advance for the rant) it is sometimes quite frustrating to see that some great financial blogs sometimes dilute their great material into a bigger "big bad government" picture (OMG!!! TEH DOLLAH! THEM BONDS ARE GETTING NUKED11!!111) which doesn't seem in tune with the thesis defended on other topics in the same outlets.

As you point out, bond yields have for decades now been a perfect mirror of nominal growth. Nominal growth is currently at 50 years low. Which is why bond yields are low and likely to remain low for quite some time (if you believe that debt deflation is ahead of us, and actually ongoing as we speak).

For all the talk about Zimbabwe and the Weimar Republic, Japan is indeed a much better example (debt bubble fueled by asset inflation and reckless bank lending) and yields crashed despite an explosion of national debt. Why are people so easily dismissing the idea that the same thing is going to happen in the developed West? Is it because the "Ben Bernanke is stealing money in your pocket" theme is more juciy?

Because for all the money printing being done, the money destruction is even greater (MUCH, MUCH greater). The 55tn or so of total US debt are deflating at a rate that MUCH MUCH exceeds the miserable 2 or 3 tn Bernanke is going to be able to print. The two sides just don't compare.

Add in awful organic income and wages growth, and a real estate environment that still deflates at c 20% yoy, and I fail to see how inflation is going to come and push nominal growth sufficiently high that it warrants higher bond yields.

I am happy to take the bet that US10YR will see sub 3% before it sees over 5% again.

- Joseph

Anonymous's picture

You are fundamentally incorrect to say we have a "deflation" problem, and to compare America to Japan in the 1990s. America is the biggest debtor in the world. Japan was the biggest creditor. When Japan printed money, as the world's biggest creditor nation, it had little effect since their surplus swallowed all of it and more.

The USA has a very serious problem with a possible currency event. Hyperinflation is not a function of supply and demand. It results from a failure of confidence in the currency. If and when our creditors lose faith in the dollar, we are finished. The dollar will collapse utterly and completely. Prices will soar to the sky, not because we have solid demand, but, rather, because of a sudden currency devaluation event. Prices will soar in terms of U.S. dollars, but not in all currencies. That is an INFLATIONARY problem, NOT a deflationary problem.

Anonymous's picture

See my response to your post above.

Also, what creditors? The notion that China has anything to gain from a USD collapse is not making sense to me. They need to revamp their economy into a domestic fueled one from an exports based one, and that will take a lot of time. THey can't afford a complete bust of their export base (which is what would happen with USD in the basement) without being in a serious, SERIOUS doo-doo. And I don't mean bank failures like in the US, I mean social unrest the like of which we probably can't understand from our Western seats.

Simply put, the reserve currency thing means that, as Rorschach put it in: "I am not trapped with you, you are all trapped with me".

The currency devaluation thing also never answers the question of who replaces USD. Sterling, where the central bank currently owns 1/3 of the national debt? Japan, which currently sports a very handsome 200% national debt/GDP ratio? Or EUR, and its central monetary policy which is back by ZERO fiscal support (which is the very reason why they never attempted QE in the first place, not orthodoxy as they would like you to believe).

- Joseph

(may be out for an hour or so, but will make sure to come back to your answer, as I appreciate this exchange of ideas)

Broken_Trades's picture

isn't most of the debt in the world deonominated in USD?

Won't this cause a mad rush for dollars once the mark to fantasy show ends?

Can you pay trillions of USD debt with Euros?

 

And to Andy D:

What do you think this means for mortgage rates going forward?  you think the 30yr yields will drop?  This is a good thing for real estate no?

 

 

Anonymous's picture

I like how Prechter (yes, yes, the deflationary maniac, but bear with me a second) put it: "the dollar will not rally because it is the least flawed currency, it will rally *precisely* because it is the most flawed one".

350+% total debt to GDP will create a mad bid for the greenback when people realize that the "assets" and "income" backing that debt are phoney.

phaesed's picture

Great job.... nice to hear the contrary argument for T bonds.... something I've been fighting with my company tooth and nails to move them into.

phaesed's picture

Are you kidding me? I've already let them know I'm leaving... I cannot stand watching them invest massive amounts of client funds with no idea about how to manage money and consistently mistaking inflation and a bull market/bear market rally with superior intelligence and investment skills. They have lost so much money and yet still the pressure is on to find more clients and convince them to place their funds into this ponzi scheme. This rally might go on until October, or even March, either way, I'll be waiting.

Getting hammered the first time around was excusable, but this time around? They can bite me. Their inability to think for themelves has made me lost all respect, they do not look for the answers, they want to be told what to do. The RIA industry is a joke and will hopefully be revealed as such very soon. The only shame about that part is how much money they will lose the retirees who depend on these "experienced professionals" for their livelihood.

phaesed's picture

No I know what you mean, I meant the same, it's not all managers, just the vast majority.

Anonymous's picture

When the stock bubble pops, isn't a stampede to safety, and a rally in treasuries to be expected?

Anonymous's picture

It's not that much the flight to safety than the fact that really, there isn't much stuff that is going to yield 3.75% per year over the next 10Y.

USTs track nominal growth to a T. If you're bearish on nominal growth, then USTs are going to be a killer, even at these prices.

It will eventually end in a bubble, but we aren't there yet IMHO.

Anonymous's picture

Thanks. #35822

Anonymous's picture

And thanks. #35822

Anonymous's picture

Andy you should have also managed to include that anyone around the world that would like to buy US BONDS will have to buy in USD. One of the reasons that nobody has bought bonds is because QE...if Bernanke lets them "really float" ie not indirectly buying them either...you can be assured people will start to pick them up especially from oversea's. I think you should have mentioned the USD as it is a huge component in your analysis. Further more I have yet to find ANYONE who is bullish USD...I emailed Tyler a chart when it broke support and I told him I was bullish....I

I totally hate the trade and long term bearish as a MF...but I would not be shorting DXY or bonds now...Also great example with Japan...most people forget that rates are under 1% well along the curve.... Also analyze the basket of the DXY index...many are just breaking out to the upside...a few neutral and one bearish......again. I hate it but EVERYONE is talking it down...time to go the other way IMO. Well done.

Anonymous's picture

Euro is being supported by EM central banks for the moment. Recovery ---> EM capital inflows, mostly dollar-denominated ---> need for diversification ---> huge EURUSD bid.

Once either of these two happens:
1. economy relapse, no more capital inflows to EM so no need to dump dollars to get euros to diversiy reserves

or

2. EM *FINALLY* a) understand how meaningless it is to have so many FX reserves in the first place and decide to let their own currencies appreciate to boost domestic demand (the whole rebalancing story) b) stop accumulating dollars to artifically crush their FX and therefore c) USD depreciates versus EM, but kills G10 as no more diversification flows

Once either of these happens, EUR is going to be in serious trouble.

Do NOT confuse growth and liquidity. EUR is posterboy for liquidity play.

Anonymous's picture

True dat.

But point 1 occurs first, that will be the second time in the same cycle that these guys get CRUSHED. It will probably make them re-think their model, dont you think?

Also, more generally, debt destruction, collapsing US consumption and the soaring saving rate means the US current account is closing. Therefore, on the long run (ie when we're past this moral hazard craze) BRIC simply won't have that many dollars to recycle.

DXY vs the US current account is a chart that has many a dollar doom-monger at my firm looking at me like I am coming from Melmac.

Printfaster's picture

It is the rush for risk.  Chasing yield or chasing alpha.  The retirees need income, whether individuals or pension funds.

They will all chase risk until they are all wiped out.

 

ghostfaceinvestah's picture

The recession is over so bond yields will go up, simple as that.

Anonymous's picture

Long TLT, UUP.
Short SQM. This got a boost tonight when Cramer recommended it. Booyah!

frozenfood's picture
frozenfood (not verified) Aug 14, 2009 11:55 AM

For the purposes set forth in section of this title, the corporation is authorized, pursuant to commitments or otherwise, to purchase, service, sell, lend on the security of, or otherwise deal in mortgages

EQ's picture

There is some attempt at rationality in your post but any comparative to Japan is completely faulty.  The rise in US savings rate will not offset anything.  Nor will it fund the US debt.  Nor are we moving towards a nation of savers.  We are moving to a nation of bankrupt consumers.  One must take into account international dynamics when looking at both Japan and the US situation.  Japan was a capital producing Godzilla.  The US is a capital consuming paper bag.   And even with all of Japan's efforts at QE, it has been a miserable failure that is actually starting to reach critical mass.  The savings rates in Japan are plummeting.  In other words, the very policy you articulate as working is having the long term effect of destroying the Japanese economy.  The US will either eat much of its debt or selectively default.   Don't be too bullish on bonds.  Seriously.