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Are Treasuries FINALLY the Short of the Decade?

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Published : March 15th, 2012
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Category : Editorials

 

 

 

 

For years now, US government bonds have looked like terrible investments, what with those trillion-dollar deficits and multiple wars and all. But Treasuries just kept rising, earning their owners nice returns and making their critics seem like financial illiterates who didn't know a AAAA credit when they saw one.


Check out the chart for TBT, a 2X negative long-term Treasury ETF (in other words, a fund that bets against Treasury bonds). In case the price numbers are hard to read, this fund peaked at 70 in 2008 and has since fallen steadily if irregularly to less than 20. Far from being the short of the decade, Treasuries, especially if you were using leverage to bet against them, have been a sound-money investor's nightmare.




But two things are true of bubbles always and everywhere: They tend to go on longer than a reasonable analyst believes possible. And they burst when fundamentals finally win out. Treasuries will go the way of all bubbles someday and, just maybe, today is that day.


The eurozone can has been kicked way down the road and the US economy seems to be improving, which lessens the urge to hide in safe havens. Risk on, in other words. And today Treasuries got absolutely smacked, with TBT jumping by 5%, a huge move for any bond fund. Here's a take on the market action from Forbes:


Treasury Market Exuberance Leads To Violent Sell-Off


A violent Treasury sell-off began after Tuesday's FOMC statement, as bond markets reacted to an improved economic environment, a more optimistic Fed, and the reduced possibility of QE3 in the immediate term, at least for now. While Treasuries appear to be more "fairly" priced, according to Nomura, the possibility of a flare up in Europe, along with a worsening of the domestic outlook, could see fearful investors jumping right back into Treasuries.


Yields on 10-year Treasuries finally broke free from a tight trading range and jumped to 2.27% by 2:50 PM in New York on Wednesday, hitting their highest levels since October.


The trigger was Tuesday's FOMC statement, where the Fed acknowledged an improvement in labor markets, the continuing economic recovery, and the temporary uptick in inflation (on the back of rising oil prices). Shortly after the Fed statement, JPMorgan said in a press release it had passed the stress tests with flying colors, prompting the bank run by Jamie Dimon to announce a dividend hike and a big buy-back.


Jamie Dimon's ratification that the economy is indeed better was the final straw, exacerbating the sell-off, according to Barclays. As market players factored in the diminished possibility of a third round of quantitative easing, along with the increased possibility of a rate hike coming earlier than expected, Treasuries plummeted. Gold fell in tandem while the U.S. dollar rallied.


"A new dynamic has been set in motion [as] complacency was widespread," explained Nomura's fixed-income strategist, George Goncalves. USAA's Didi Weinblatt, VP of mutual funds and a fixed-income expert, added that "rates were artificially low," helping make the move that much more violent. "Everybody that was riding with the Fed got out at the same time," she added.


Weinblatt warned that markets remain schizophrenic, oscillating between risk-on and risk-off on any headline. Fundamentally, she believes, rates should be a lot higher, but "the Fed is still doing the Twist, Bernanke has QE3 in the backburner, and Europe could still flare up," once again sending investors scrambling for the safety of Treasuries.


Nomura's strategists believe Treasuries are now closer to "fair value," and have a medium-term target of 2.4% for 10-years. While most bond sell-offs start this way, and yields "had no business staying under 2%," a worsening of the domestic or global environment could dramatically change things in a very short time frame, as Tuesday's price action illustrates.


Is this the turn for Treasuries? Well, they're certainly not "fairly valued" on fundamentals. The long bonds of any country with government debt and total debt exceeding, respectively, 100% and 350% of GDP are an automatic short, just on simple math. But the US, as the printer of the world's reserve currency, is a special case in terms of timing. When trouble strikes elsewhere, people still come here to hide. So even in the face of ridiculous, Greek-like numbers, the dollar continues to function as money and Treasuries continue to find a bid.


There will come a time when shorting Treasuries is the trade that makes fortunes and reputations just as surely as did shorting mortgaged-backed bonds in 2007. But as with any other bubble, it's best to wait until the market shows clear signs of cracking before jumping in with both feet. Time will tell whether today's action is that kind of sign, but when such a sign does come, it will look a lot like this.



 


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