Thursday, January 15, 2009

Maybe The Bond Market Is Right

In a previous post on long term Treasury bonds, I reviewed some of the technical factors that have me bearish. "So it is highly likely, from this perspective, that Treasury bonds will be an under performing asset class over the next 12 months. But more importantly, will this market top lead to an investing opportunity (i.e., by shorting Treasury bonds)? In other words, will the market top lead to a secular trend change in Treasury bonds?"

On this, I am a little less certain. As we know, many (i.e., see the Barron's story, "Get Out Now") are calling for a top in Treasury bonds, yet as I contend, market tops don't occur when we all expect them too. Furthermore, I wonder if betting against bonds is a good strategy as a bet against Treasury bonds is a bet against the US Government. The Federal Reserve and Treasury have made their intentions known and are likely to support bond prices.

But what if bond market participants are right? What if they are buying not because there is a flight to safety (due to losses in other assets) but because they see value in borrowing at 0% and buying long dated Treasuries that yield between 2-3%? In a deflationary environment such as seen in a recession, this certainly makes sense.

In essence, buying bonds is really a bet that the Fed's reflationary policies will not work. Buying bonds is a bet that our economic malaise will continue much longer, and this notion is clearly supported by the data. See figure 1 a monthly chart of the yield on the 10 year Treasury bond. The indicator in the lower panel is an analogue representation of the National Bureau of Economic Research's (NBER) expansions and contractions. The NBER is the government organization that officiates over the beginning and ending times of a recession. On the graph, the gray vertical bars highlight recessions. The relationship between Treasury yields and economic contractions is easily seen. It would be highly unusual for yields to rise during a recession.

Figure 1. 10 Year Treasury Yield v. NBER/ monthly

Let's look at the relationship between Treasury yields and economic activity in another light. See figure 2 a monthly chart of the yield on the 10 year Treasury bond. The indicator in the bottom panel is 12 period rate of change of the Leading Economic Indicator data from the Economic Cycle Research Institute. As noted in a prior commentary, there is a very strong correlation between negative indicator readings and contracting economic activity. The gray vertical bars highlight economic contractions.

Figure 2. 10 Year Treasury Yield v. ECRI LEI/ monthly

In 10 out of the 11 instances sited, long term Treasury yields headed sharply lower during the economic contraction. The lone exception was in 1974, and yields went higher only to retrace that move once the expansion took hold.

If the past relationship between Treasury yields and economic activity is any guide, we should not see Treasury yields rise while the economy is contracting. However, once the Fed's policies begin to take hold and when the economy begins to expand, then it would seem more probable that a secular trend change for yields is on the horizon.

My bearishness on Treasury bonds is based upon the 'next big thing" indicator, which is a tool that I have developed that helps me identify the potential for a secular trend change in an asset. I have shown this indicator in figure 3, which is a monthly chart of the 10 year Treasury yield with the NBER data in the middle panel. Recessions are identified with the vertical gray bars and peaks in the indicator, which correspond to a bottom in yields, are noted with the maroon colored bars. The indicator is in the extreme zone, and once again, suggestive of a top in bonds or at the very least, Treasury yields should not go much lower.

However, the real story of figure 3 is this: bottoms in yields don't come during economic downturns, and more often than not a bottom in yields will come once the economic expansion is well on its way.

Figure 3. 10 Year Treasury Yield v. NBER v. "Next Big Thing"/ monthly

It does not seem likely that long term Treasuries will sell off (i.e., leading to higher yields) until the economic landscape improves. However, given the size of the Fed's stimulus response so far that sell off could be brutal once our economic fortunes improve. Given that the "next big thing" indicator is in the extreme zone, it is worthwhile keeping this asset class on the radar screen.


EquityBell said...

There is one crucial area that you have not covered that supports your bearish stance. In my recent market commentary (see we noted the following.

"Every economy in the world has been hit by the recession, but countries that are leveraged to Western consumer (like China) have been hit hardest and fastest. Social and labour unrest is increasing and there have already been strikes and protests in Guangdong (China’s export manufacturing region) as workers have been laid off following the collapse of consumer spending. China now holds US$650 billion of US Treasuries, which is up US$190 billion over the last year, but their recent purchases have slowed considerably. If you add in other known holdings, analysts suggest that China owns $1 of every $10 of America’s entire public debt.

The most pressing question is what the Chinese government will do? The number one guiding principle of the Central Committee of the Communist Party of China is to retain power and control over a vast and diverse population. Domestic interest will always come before foreign consideration. Beijing could maintain the status quo by keeping the Yuan low against the US$ to make their goods affordable and keep lending money to the USA. However, the Sino-bashing camp in Washington could be the tipping point for China to sell some of their bonds to finance domestic stimulus. China will need time to adjust to domestic market manufacturing, but will probably be the first global economy to embark on recovery. All of this will become clear over the next three months. Look for signs of Chinese domestic stimulus coupled with heavy selling of US$ Treasuries and a declining US$".

Therefore, the US$ yield curve is likely to steepen as the Fed stimulus keeps short rates low and overseas investors who have better use for the cash sell bonds and repatriate the US$.

What do you think?

Guy M. Lerner said...
This comment has been removed by the author.
Guy M. Lerner said...

Let me get the link correct.

Zip: I hear what you are saying and I am aware of this scenario, and as weakness spreads across the globe, countries are likely to take care of their own instead of taking care of US debt. Obviously, China is the biggest risk in this scenario.

However, I came across a good analysis to suggest that just maybe the buying is Treasuries is for real -i.e., there is true demand. This was the point of my article. And because of this demand, the lack of buying from China will not make a difference.

The link to that article can be found by clicking here.