Don't Be Too Bearish on the Bonds, Seriously

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):


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).