Last week Bloomberg ran a story titled, “Can’t Find Enough 30-Year Treasuries to Buy? Here’s Why.” In the article the author highlighted all the bullish reasons why the long end of the US Treasury curve has been rallying.
According to Bloomberg subdued inflation, pension plan buying and competition from the Fed’s QE programs are some of the reasons for this rally. But the main reason seems to be attributed to a “potential shortage of supply.”
I can’t help but laugh at how the narrative has changed so dramatically over the past couple of months as the bond market has rallied so unexpectedly.
US 30 Year Treasury Yield</a> </div>
At the beginning of the year when yields were 4%, apart from the perpetual bond bulls like Gary “deflation forever” Shilling, there were precious few market participants that were forecasting a bond rally (decline in yields).
Now that we have had 4 straight months of bonds rallying incessantly, the tone has completely changed.
All of sudden the biggest worry is no longer the Fed’s tapering, but instead a “shortage of supply.”
Over the last couple of weeks I have also noticed some of the fast money type accounts getting long the bond market. This was something that was missing at the turn of the year.
I understand the motivation.
The 30 Year Treasury yield has backed up a fair ways from the lows of 2.5% seen in the summer of 2011. As compared to other big bond markets, the US market offered good value. Have a look at the US versus German 30 year yield:
US 30 Year Yield (white line) vs German (yellow line)</a> </div>
Even compared to the inflation rate, the 30 year had backed up to the point where real rates were firmly positive. Have a look at the US 30 year real rate:
US 30 Year Real Rate</a> </div>
Although it is still somewhat low by historical standards (the 30 year real rate has averaged much closer to 3.5% or 4% during the past couple of decades), if you believe that we have entered into a new era with permanently lower real rates due to constant financial repression, then a 2% real rate offers a fairly attractive return versus the negative real rates we experienced a couple of years ago.
At the beginning of 2014, when the US treasury was yielding 4% (which corresponded to a real rate of more than 2%), the fear from the taper was quite thick. As usual the hard trade of buying Treasuries into that dip was the right trade.
I have long argued that contrary to popular wisdom, QE programs are not bond market friendly. Given the Fed’s tapering of the QE program, this bond market rally is therefore not wholly unexpected.
However, the Fed has added enough monetary fuel to the fire that even the removal of QE programs will not be enough to put out the flames of inflation.
The fast money trader types that are buying the long end of the bond market are taking a big risk that the winding down of this third QE program looks similar to the previous two. If they are correct and the velocity of money keeps falling, then the 30 year will offer exceptional value and there could be a mad scramble to buy one of the few assets that offers a guaranteed positive real return. Over the past few months, as the Fed has stuck to the tapering plan, the probability of this outcome has increased. It therefore makes sense to bid up Treasuries.
However for those that believe that the velocity of money has bottomed and that the economic recovery has reached a self sustaining momentum level, then this bond market rally offers a wonderful opportunity to re-establish a short position.
I may not know much, but I do know that when articles about the “lack of supply” of Treasuries hit the tape, the risk reward does not favour the longs. If there is one thing that I can count on, it is that Wall Street figures out a way to satisfy that demand.
I don’t see the trend of ever increasing levels of US government debt changing anytime soon. Have a look at the chart of the Total US Public Debt outstanding over the last few decades:
US Total Public Debt Outstanding</a> </div>
There are no meaningful declines. The best performing periods are simply a levelling off of the increase.
Now maybe I am missing something and the US deficit is about to disappear and the debt is indeed going to decline. But even if it does (which it won’t), then the 30 year yield is still at multi-decade lows:
US 30 Year Treasury Yield</a> </div>
Given that absurdly low level of yields, if there truly is a lack of supply, wouldn’t it make sense for the US government to shift their borrowing out the curve? In fact this is what countries like Canada are doing with their recent floating of a 50 year bond.
The rally in the bond market over the past few months has caught a lot of market participants off guard. The QE taper has not had the effect that most would have anticipated, and now they are scrambling to buy bonds. Hedge funds, sensing this mis-positioning have decided that it is time to squeeze these shorts.
However, I think that the bigger picture trend of higher rates is still intact.
Given the shift in tone from “tapering is going to cause the bond market to collapse” to “there is a shortage of bonds”, I think the time is upon us to try to the short side of the bond market again. The hedge funds are pushing their luck on a counter trend trade.
I believe that the tide has turned for the velocity of money and that the Fed is going to overshoot their target with the recent money stimulus. This bond market rally has given me a chance to enter into a trade to take advantage of this belief at great levels.
I am starting to ease into a short 30 yield Treasury position. I will put on a bit at the 3.48% level, hoping for a bond rally into the 3.2% level to put out some more.
Last week I put on a CAD short, and with my usual impeccable timing, CAD proceeded to rally to new highs almost immediately.
However on Friday Canada released their employment figures. They were terrible. Economists were expecting a gain of 12k jobs but were instead greeted with a decline of almost 29k jobs!
Although the market gods are intent on making my short CAD call look foolish, even they couldn’t ignore that news. CAD stopped its rally on the release.
USDCAD rate (higher means weaker Loonie)</a> </div>
Although the economic fundamentals seem to be headed my way, so far it has not moved the trades that I have put on to take advantage of this development. My short EDU6 long BAXU6 trade continues to simply move sideways:
EDU6 (white line) BAXU6 (yellow line)</a> </div>
I am going to hang tight as the economy is behaving as I predicted, but I am concerned that it is not translating into trading profits. I am going to keep a close eye on these trades in the coming days. Sometimes the lack of reaction is a clue… the trick is knowing when the market is simply a little slow and when the market has fully baked in the news. If someone knows how to consistently tell the difference, then please let me know.