Why US Treasuries Are Set to Fall, And How You Can Profit From It

Simit Patel · 11-04-2008, 06:54 PM

Understanding the bond market can help us understand what is going on from a macroeconomic perspective, and how other financial markets may react. Here are the key points traders should consider:

1. The Fed is looking to lower rates, and appears to be headed towards zero percent. The Financial Ninja has an interesting post on this subject, which I recommend. So the Fed is expanding the monetary base, but as banks have been refusing to lend, the effects have yet to be inflationary. However, should lending resume, the Fed's attempts at expanding the money supply could result in inflation, which would increase the yield that bond buyers demand. As bond prices and bond yields are inversely proportional -- meaning an increase in bond rates will decrease the price of existing bonds issued at a lower rate -- this would result in falling bond prices.

2. Moreover, the US national debt is just getting started. CalculatedRisk tells us that the national debt is now over $10 trillion and rising quickly. But of course, debt, like anything else, does not have infinite demand, and competes with other financial assets for investment dollars. To ensure that demand for debt increases as supply for it does, the rates on government bonds may need to increase. This would send the price of existing bonds down, while sending interest rates up.

3. The other option is that the Federal Reserve simply buys the government debt. This could prove to be immediately inflationary, and would decrease the value of dollar-denominated assets, including outstanding bonds issued by the US government. This would push bond prices down.

In many ways this is at the heart of the inflation vs. deflation debate, which I've talked about regularly here on my blog.

Leading Indicator: Credit Default Swaps

Credit Default Swaps (CDS) can be thought of as an insurance policy that protects debtholders against the default risk of their borrowers. Credit default swaps are currently pricing in an increased of default on US government bonds. Prudent Bear explains:

Quote:

Originally Posted by Prudent Bear

According to data provided by CMA DataVision, the credit specialists, the 10-year credit default swap spread – a form of insurance contract against issuer default – has risen steadily - from 1.6 basis points (0.016%) in July 2007, to 16 basis points in March 2008, to 30 basis points in September, to over 40 basis points on October 27 – see the chart below for the spread history so far this year. In other words the cost of insuring against a US government default has risen by 25 times in little over a year. Similar trends have been evident in the UK and German government bond markets.

The more default risk the market expects, the more bond buyers will refuse to buy additional debt or will demand greater interest rates for doing so.

How Can You Trade This?

And so, we can conclude with the most important question: how can you profit?

If you want to trade this scenario, TBT -- the ETF that is twice the inverse of the daily performance of the Lehman Brothers 20+ Year U.S. Treasury index -- is a good option, and has been recommended by esteemed investors like Jim Rogers and Marc Faber. Also worth noting is that the yield 30 year US Treasury bond recently hit a 30 year low, and has been rising since -- this is one indication that the Treasury bond bubble may be bursting. The Daily Reckoning has an insightful article on this subject.

David Waring · 11-04-2008, 08:54 PM

Hey Simit,

Great post and on a topic which I think is going to start to get a lot more mainstream press as well as one that will have ramifications on all markets, not just the bond market.

Like CDS spreads should be a good indication of a potential risk premium being built into US Government rates, TIC Data which measures net foreign security purchases, should be a good indication of the foreign demand side of the equation.

Brad Setser's blog from the Council on Foreign Relations provides great analysis on this piece of the puzzle and actually had a very good post today regarding how a falloff in demand from foreign central banks may not cause rates to rise in the current environment. He sums this side of the argument up nicely with the following statement:

Quote:

Nonetheless, central banks are unlikely to match the extraordinary pace of reserve growth that characterized much of 2007 and 2008. That though doesn’t necessarily imply that US Treasury rates will have to rise dramatically to induce private investors to absorb the increase in Treasury supply. Not so long as economic climate remains so bad. Yesterday’s data was awful. And the recent fall in consumption suggests that Americans will soon start saving a bit. Their appetite for risky assets has already fallen. That means more demand for safe assets. Investors who reached for yield in the boom times got burned; many may play it safe.

I will have to see and plan to look into more data before I make up my mind on this issue from a long term perspective but I thought it would be worth sharing the other point of view for everyone's knowledge.

Best Regards,
Dave

David Waring · 11-05-2008, 12:09 PM

Have been doing some additional research on this and the more I see the more I like this trade. I am going to look to trade the TBT however I am going to wait for a break of the trendline on the below chart, or a test of the highs, before doing so. The TLT is the unleveraged ETF which tracks the bond index that the TBT is the double inverse of, so it is more actively traded and therefore in my opinion a better chart to make decisions off of when placing trades in the TBT.

TLT Daily

David Waring · 11-07-2008, 09:13 AM

Interesting post today from Bespoke Investment Group showing the CDS rates for about 40 countries ranked in order from most likely to default to least likely to default.

A few things that came as a bit of a surprise to me here.

1. Germany is ranked lower than the US in terms of default risk as judged by CDS rates. While I know that CDS rates for US debt had increased dramatically I still thought the US would be considered by this market to be the least likely to default.

2. While many people argue that China is the place to be, going by this report in isolation they are still 3.6 times riskier from a default perspective than the US.

Best Regards,
Dave

David Waring · 11-07-2008, 09:31 AM

More data for the discussion on the Fed's balance sheet from Calculated Risk.

Stephan · 11-08-2008, 03:03 AM

Hey Simit,

Agree totally that we are likely to see higher treasury yields over the coming quarters, and to be honest, I was expecting it to happen quickly until very recently, but my enthusiasm has been somewhat dented over the past week.

First of all I am completely out of the 0% Fed Funds camp. The mere suggestion that the US is entering a Japan style vicious cycle, pushing rates to zero, and having no so called ammunition left should be enough to scare Bernanke to high heaven. In effect, the Fed effective rate is hovering near 0.2% anyways, substantially under the 1% target. They are doing everything they can to encourage lending, but obviously the banks are too thinly capitalised and afraid to on-lend to the real economy.

Secondly, China, which has pursued growth at all costs, building everything and anything at breakneck pace to maintain full employment is grinding to a halt thanks to the looming global recession. The Chinese government is petrified of the potential public backlash to unemployment, and will therefore do everything it can to continue producing at near full capacity. This is certain to deflate prices for a wide array of goods as the market is flooded with Chinese goods at firesale prices, keeping any inflationary concerns on hold for the foreseeable future.

Thirdly, I believe the world as a whole is so risk-averse and underinvested (understandably so), that as unattractive as the treasury yields are, they will continue to garner support. The past few days we've seen the steepening of the yield curve pause as real money managers are clearly finding it hard to ignore the extra 2.4% of pickup you get by buying 10year bonds instead of the 2 year. Trading emerging markets, I have seen overwhelming demand for longer tenor sovereign paper, bringing long term yields to near record lows.

Overall, this dynamic, deflation and yield pickup might support bonds for a little while, but eventually, as you say, the demand reduction from offshore coupled with the pending supply avalanche should cause a mighty selloff, the likes of which we haven't seen in more than 20 years. As always, it's a question of timing.

Regards,
Stephan

11-07-2008, 09:31 AM	#5 (permalink)
David Waring InformedTrades Founder Community Host Badges About Assets Total Awards: 4 Join Date: Nov 2007 Location: Miami, FL Posts: 5,632 InformedPoints: 0.13	More data for the discussion on the Fed's balance sheet from Calculated Risk. __________________ InformedTrades University \| IT Shopping Guide \| Site Map Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.

11-08-2008, 03:03 AM	#6 (permalink)
Stephan Badges About Assets Join Date: Nov 2008 Location: Singapore Posts: 2 InformedPoints: 0	Hey Simit, Agree totally that we are likely to see higher treasury yields over the coming quarters, and to be honest, I was expecting it to happen quickly until very recently, but my enthusiasm has been somewhat dented over the past week. First of all I am completely out of the 0% Fed Funds camp. The mere suggestion that the US is entering a Japan style vicious cycle, pushing rates to zero, and having no so called ammunition left should be enough to scare Bernanke to high heaven. In effect, the Fed effective rate is hovering near 0.2% anyways, substantially under the 1% target. They are doing everything they can to encourage lending, but obviously the banks are too thinly capitalised and afraid to on-lend to the real economy. Secondly, China, which has pursued growth at all costs, building everything and anything at breakneck pace to maintain full employment is grinding to a halt thanks to the looming global recession. The Chinese government is petrified of the potential public backlash to unemployment, and will therefore do everything it can to continue producing at near full capacity. This is certain to deflate prices for a wide array of goods as the market is flooded with Chinese goods at firesale prices, keeping any inflationary concerns on hold for the foreseeable future. Thirdly, I believe the world as a whole is so risk-averse and underinvested (understandably so), that as unattractive as the treasury yields are, they will continue to garner support. The past few days we've seen the steepening of the yield curve pause as real money managers are clearly finding it hard to ignore the extra 2.4% of pickup you get by buying 10year bonds instead of the 2 year. Trading emerging markets, I have seen overwhelming demand for longer tenor sovereign paper, bringing long term yields to near record lows. Overall, this dynamic, deflation and yield pickup might support bonds for a little while, but eventually, as you say, the demand reduction from offshore coupled with the pending supply avalanche should cause a mighty selloff, the likes of which we haven't seen in more than 20 years. As always, it's a question of timing. Regards, Stephan Last edited by Stephan; 11-08-2008 at 03:07 AM.

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