Monday, January 5, 2009

Are Treasuries Really in a Bubble?

A Barron's video posted at The Big Picture warns to 'Stay Away From Treasury Bonds'. I'll agree that Treasury bonds look awfully rich and I have no intention of going long, but I do feel there is danger to outright shorting treasuries in this environment (though as I post this, 30 year yields have blown out 20 bps today). First lets look at some data that shows at a minimum long bonds (i.e. 30 year Treasuries) appear rich.

30 year treasury yields have rallied dramatically over the past 25+ years, but the most recent rally is unprecedented over that time.

In terms of pricing, long bonds have rallied more than 30% in the past 3 months. Supporting the case that these bonds are ready to sell off... long bond prices have historically sold off ("mean reverted") following smaller, yet similar rallies.

However, it is important to remember that the current market is not "normal" and mean reversion is not a certainty. Off the top of my head, I can think of many reasons why long bond yields may not only stay at current levels, but may actually continue to rally.

  1. Real yields are not abnormally low (a deflationary environment makes those puny yields much better in real rather than nominal terms)
  2. The Fed can (and will likely be) purchasing Treasury bonds to keep rates artificially low; likely starting in the 5-7 year space, but possibly out along the curve
  3. The economy can continue to get worse / companies will default in the coming year at substantial levels, creating the possibility of another "flight to quality"
As Larry MacDonald states in his post Shorting The Bond Bubble? Hold On:
Shorting government bonds would thus appear to be a no brainer as risk appetite responds to signs of an upturn in economic growth and inflation worries arise anew. But what might not be so obvious is the timing of the trade.

Lags in the impact of stimulus measures could mean deflationary news will linger for awhile yet. More importantly, the Federal Reserve has stated it is committed to buying Treasuries to keep interest rates low until the crisis and economy stabilizes. China too will likely be a buyer of U.S. Treasuries as part of its strategy of suppressing the yuan to enhance the competitiveness of its exports.

So watching from the sidelines may be the strategy for now.
Update: My post was all set to go when I saw Credit Writedowns had an eerily similar post. Always nice to be in good company.

1 comment:

  1. Jake,

    Great analysis. You know I agree with you 100% about not going short. Maybe the best thing is to stay away because the outcome is very unpredictable. There are plenty of more rewarding opportunities to choose from.