Bonds Away?

One of the great things about comments is their ability to provoke new thoughts. A response to my recent update on the Euro noted that TBT, which is a leveraged ETF that moves inversely to the price of U.S. Treasury bonds – which means in practice the 30-year “long bond” – will be the trade of a lifetime. That reminded me that I’ve been thinking that for several years now, more or less since the Fed was handed the task (or took it upon itself, depending on your view) of keeping the economy and financial system functioning by adding extraordinary amounts of liquidity. This has been done by keeping the discount rate at which banks can borrow at effectively zero, and by purchasing bonds (“Quantitative Easing”) from banks, adding long term reserves to the money supply.

In most if not all Econ textbooks, it is explained that adding to the money supply, especially in extreme quantities, will tend to get the economy moving, at the price of increasing the rate of inflation. Since inflation is anathema to bonds, particularly those with long maturities, TBT should have been a slam dunk. Instead, as the chart above indicates, it has experienced a prolonged grind lower, and although stochastics are now in the low single digits, it doesn’t really show any signs of a reversal. How can this be?

Part of the answer reflects supply and demand. The “risk off” trade, in which investors look first for “return of principal” rather than a “return on principal” favors Treasury bonds, still the standard due to the Dollar’s status as the world’s reserve currency. That creates demand , although it would be expected to be more pronounced in the shorter end of the yield curve. That’s part of the answer too, however; the U.S. finances its budget deficit by selling T-bills, notes and bonds, but the supply of long bonds is finite, since most of the instruments issued have maturities of ten years or less.

One of the characteristics of institutional investors that I’ve observed over the years, particularly in the case of macro hedge fund traders, is that they’ll keep doing something that works until it costs them money twice in a row. As the chart above of the T-bond contract (US) indicates, owning long Treasuries has been working for a while. As the gent who posted the comment suggests, when it turns, it should be tons of fun, but that hasn’t been the case to date, despite all of the negatives. Fixed income investors do typically have some allocation to long Treasuries, so there will be some demand on dips in response to any initial weakness.

How vulnerable are holders of long Treasuries to a squeeze? I know a fair number of institutional fixed income managers, and most of them, as noted, have some allocation to government securities, including the long end of the yield curve. Many are already underweight relative to their benchmarks, since the risk/reward on long bonds hasn’t been attractive for quite some time. Pension funds need more yield than is currently available from government securities, and have been busily buying up corporate debt, particularly high-yielding ETFs backed by corporate bonds, which avoid the liquidity problems that lead to wide bid/ask spreads in mature corporate issues. If yields move sufficiently higher to provide the income that they need, I suspect that they’ll be better buyers than sellers.

The other big holders are foreign central banks and sovereign wealth funds. They are unlikely to be big sellers when confronted by weakness; the U.S. trade deficit may narrow, but it seems unlikely to go away, so these entities will keep collecting Dollars. They may not be happy about the prospect of having the value of their holdings decline, but they’re stuck; they want Euros even less, and all of the other bond markets combined can’t come close to offering them enough outlets for their balances. They will continue to buy Treasuries, and will likely continue to represent a sizable percentage of the bidders at long bond auctions.

Anyway, these are offered as some weekend thoughts. I lost some money a couple of years ago trying to anticipate the turn in rates. All of the factors that convinced me that it was time for yields to go up and prices down (which would move TBT quickly higher) remain in place, and it will be a great trade at some point. When the move to higher rates, and thus a higher TBT, occurs, it should be a secular move, lasting for years. There doesn’t seem to be any urgency about trying to catch a bottom. In the futures, support looks to come in around 145.18; a break below that level might prompt a look at taking a starter position in TBT. On the daily chart of TBT, a move over 16.10 or so would represent a break of recent resistance, again possibly serving as a signal to initiate a starter position that can be added to as it demonstrates that it’s working.

 

About the Author Brian Keith

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