Thursday, December 18, 2008

Is the Treasury market a bubble?

Yields on U.S. Treasuries have fallen to levels once thought impossible, and we are now hearing the "B" word (bubble) used to describe these formerly staid securities. Just a few days ago I was resisting the bubble label, but with the 10-year dropping below 2.10%, its getting very hard to argue. But more important than assigning labels like "bubble" is to discern what could cause the Treasury market to move in the other direction. In other words, if its a bubble, when can you short it?

First, consider who is driving the Treasury market to these levels. It isn't relative value investors, like money managers and mutual funds. Sure they might hold some amount in Treasury bonds for liquidity and duration management. But these kinds of managers are generally assuming that Fannie Mae and Freddie Mac debt has equivalent credit quality as Treasuries with substantially better yield. So investors who are willing to consider relative value have already reduced Treasury holdings as much as they are likely to any time soon. So selling pressure isn't likely to come from relative value buyers.

Foreign buyers have dominated the demand side of things, buying up just over half of net Treasury issuance in October. Why are they willing to buy at historic low levels? Classically foreign buying of U.S. bonds has been due to recycling of trade dollars. In other words, foreign money will keep flowing into the U.S. so long as U.S. consumers are buying foreign goods. Foreign buying of Treasuries has been especially robust among private accounts (not central banks), which suggests that foreign financial institutions are driving demand.

A slowdown of foreign buying would clearly push rates higher, but in the near term, what would be the catalyst? Note that foreigners have been paying for their Treasury bonds by selling government Agency debt, $50 billion worth in October. This is reflective of a lack of confidence in any security not directly backed by the U.S. Government. The Treasury could make the backing of Fannie Mae and Freddie Mac explicit, but even this won't instantly reverse selling of Agency securities. Foreign trading is notoriously slow-moving, often waiting for bond maturities to reinvest rather than trading their portfolios.

Many of those calling the Treasury market a bubble are ignoring the threat of deflation. Under deflation, normal perceptions of interest rates as well as relationships among interest-bearing instruments break down.

Of course, we don't need investors to sell to create selling pressure. The Treasury is doing plenty of selling of its own. If investors, both foreign and domestic, gained more confidence in financial institution generally, they would move out of Treasuries and into better yielding, high quality bonds. But that will be a slow process. But until this happens, demand for ultra-safe investments will continue unabated, keeping a lid on Treasury rates.


Keith said...

I certainly can concede that with the risk of deflation, it could be hazardous to short the short end of the curve. But the 10 and 30 years? Those rates will absolutely go up some time before they mature. Shorting them seems something of a no brainer.

Anyone have any advice on how to short the long maturity Treasuries as an individual investor?

Accrued Interest said...

Take a look at TBT, leveraged short against 20yr Treasuries.

Here's my thing. I buy deflation for the next year, maybe two years. But 10? No way.

GS751 said...

I agree with Accrued Interest. The current destruction of wealth is incredible.

Anonymous_1 said...

Piling long into TBT, PST, RYJUX or short TLT is probably 6-24 months out on the horizon. I agree, the threat of deflation must wane first, and the Fear of a new depression must subside. After that, inflation, due to Fed printing presses running 24/7, should dominate the market's psyche, and then it's on to early 1980's style 30-yr yields. Unwinding the MBS House of Cards is a slow process.

Anonymous_1 said...

Sorry, I need to add a discliamer.
Disclaimer: I'm still long TLT.

Darth Toll said...

AI, what you are saying is true about bond yields and where the likely source of selling pressure would come from, if any. However, you make no comment on the actions that the government and federal reserve have taken to drive everyone into the bond market in the first place.

As you've probably heard, at some point the lender of last resort becomes the lender of only resort and these actions are clearly creating a massive crowding-out scenario that will lead to a bond collapse in the not too distant future.

I don't believe that the fear of a new depression will subside. Rather, folks will discover that the Fed's actions have crowded out the private sector credit markets and have destroyed them. Ultimately this will lead to a treasuries collapse followed by GD2. This environment is similar to the Fed's actions following 1929 and led directly to the bond collapse of 1931-32. And that's when the real trouble began. What we've seen so far isn't the actual disaster that's coming, its simply building up to the real disaster.

Now the more paranoid among us would say that the Fed is doing this on purpose (funneling everyone into treasuries and then knocking them over) to destroy the private banking system so they can further their monopoly as in GD1, but I'm not ready to go there yet. But I'm sure you heard about the Fed's plan to issue their own debt not backed by treasuries, no? Undoubtedly this would be the senior offering and would shaft all of the treasuries holders with one brilliant stroke.

Accrued Interest said...

Darth: You're view is popular in many circles, but to suggest a crowding out implies that there is private sector lending that would be occuring if not for government interference.

But look around! In all areas of lending, other than where the government is interfering, lending is very strained.

A better argument is that if the government doesn't get its deficit under control it could eventually crowd out lending in the future.

I personally think starting to build a TBT position is OK, but think of it as a trade, not as a long-term home run. If its a bubble, it could go much further before bursting.

Anonymous_1 said...

I thought I would get stopped out of my TLT last week, but it didn't happen. If you'd told me that the 30 yr would hit 2.6, I wouldn't have believed you. At this point, I wouldn't believe a 30 yr under 2, but I'll move the stops if it happens. Agreed, there's no reason to start a TBT position unless you're in a trading mood. Trend traders should wait. Better to be a little late to the party, then show up 6 months too early.

jonathan said...

If you're going to short the long maturities, be prepared for a rough ride. Long rates will tumble before they go up.

Darth Toll said...

"In all areas of lending, other than where the government is interfering, lending is very strained."

That's my entire point and is a symptom of the crowding-out effect. If the Fed, for reasons malignant or benign, becomes the lender of last resort and only resort, you would expect exactly this symptom! It's a little of a chicken and egg argument, but I would maintain that the private credit markets could have and would have cleared without all of the massive interventions and that said interventions and phony panics will (and are) creating a lender of only resort environment where only explicitly backed government issue gets a bid and nothing else does. Can a 2% ten year be anything other than massive crowding out?

Then, when everybody is "all-in" the bond collapse will happen. How does this differ from 1931? BTW, I'm not sure the term "bond bubble" really describes what is happening. More like an orchestrated power grab and engineered panic for consolidation and banking monopoly purposes. Line up the bowling pins and then knock them over.

Speaking of which, what do you think about the story above where the Fed is considering issuing it's own debt?

cap vandal said...

I couldn't resist taking a little bite of the 10 year ultra short. PST.

2% doesn't make sense, at least to me. As far as real deflation, it's true that oil and other commodities have unwound. The CPI x food and energy didn't reflect the real person's experience 6 months ago and it doesn't now.

However, when are grocery prices going down? They sure as hell went up, and I have seen some weakening, but they seem sticky on the way down.

Housing is down as I expect the rental equivalent or whatever is in the indices. However, once again, this is unwinding something that never made the cpi.

I can't get over the fact that in true price deflation, the winners are the people that are supposed to be losers. Like people on social security, welfare, etc.

Plus, you have what are effectively hedge fund types promising that we won't see price deflation as they throw every quantatative easing scheme imaginable.

It is hard to get timing right, but this is more of a bet on whether if something can't continue, it won't.

What sort of default would you need on junk @ 24% to equal 2% on 10 years?

lineup32 said...

Treasuries reflects a parabolic move and such moves are prone to collapse of course just when requires a crystal ball. The volume into treasuries may reflect a large international currency flow from multi-national corps suddenly finding emerging markets unstable.

formerly of greenmonday said...

i don't believe in this move. its only been a month and its been near parabolic. a surge in a short period with less then a convincing fundamental case looks like bubble trouble.

i hear you on deflation, but, with so many countries planning to go into big deficits to fund stimulus plans - where is all this demand going to come from with rates solow?

are treasuries so much preferable to debt of canada, europe, asia? what will be the reaction when california needs a bailout? will the credit quality of the us be in question.

everything has been just nuts. oil breaking a hundred - screaming to almost $150 - and now, just 4 months later, in the low 30s. could this happen to treasuries?

Andrew Judd said...

I am not a bond expert but i think you can better understand what is happening once you release the idea that the US is in a long term decline as a world power. Everybody realises they are totally dependant upon the US economy now. Against so many forcasts the US showed strength rather than weakness.

It would be nice if the USA is less arrogant after this but it is still the most powerful country in the world with nobody else being close. People want the USD. Strange but true. It is reality.

Most of us have been totally right and yet totally wrong too. The future was unknowable.

Unknown said...

Can anyone tell me what the expected price decline of TLT would be if the longer end of the curve would continue to decline to 0. I would imagine that this plus the negative carry on the short position which is minimal would be the downside risk to the trade. correct? 0% rates should put a floor on potential losses in the short, whereas upside in position long end reapproaches 5% must be something like 50%.

chappy said...

Who, in their right mind would lock money up for 30years and accept 2.62% interest. There is no rational reason to buy it. If you want safety, the short maturities are ok. The 30 year issued on 5/15/08 with a 4.5% coupon trades at a 37% premium. That could easily evaporate once the Fed stops printing money and using it to drive yields downs so that we can all have 4.5% mortgages. BTW if was China and just made $250 billion in 8 weeks on a trade, I might book some profits.

JWOJKP said...

Ok, the original post was 1 month ago which is an eternity in this market. Any further thoughts now? To me, we have already had the perfect storm to push rates to record lows. Now you can see, not even the bonds vs stocks trade has pulled investors into the long end as stocks have almost the worst January on record. There are other factors out there other than the obvious (enomormous future supply), like if any one of the large holders (China Japan Korea Taiwan) needs to sell (or stop buying at the same rate) due to their need for funds to finance their own internal fiscal stimulus policies. That is the speculation part which of course is secondary to the observation that everything should have pushed rates lower or at the minimum, kept rates stable during this 30 day period and just the opposite has occurred. Its not a runaway but TBT would have gained something on the order of 10-12% during a month when stocks are down 5-6%. That shouldnt have occurred.