It's time to bet against the government

The long rally in Treasury bonds is set to fizzle as inflation, credit risk and the end of QE2 weigh on prices.

By Anthony Mirhaydari Jun 9, 2011 3:39PM

Over the past few months, U.S. Treasury bonds have defied the naysayers and pushed to levels not seen since last October. This came as a surprise to many people, especially since the government has already hit the debt ceiling and three major credit rating agencies have threatened to downgrade the U.S. credit rating if Washington fails to act as technical default looms in August.

 

The rise was driven by an increase in demand for haven assets as the economy hit another soft patch. Other factors included the European debt crisis, stabilization in the U.S. dollar and a whiff of disinflation as Wall Street marked down growth expectations.

 

But now, the naysayers look ready for their time in the sun as risk appetites rebound and the economy looks ready to re-accelerate and surprise newly pessimistic investors. And that means it's time to bet against the U.S. government by betting against its bonds. Here's why.

 

For sure, there are plenty of reasons to think T-bonds will head lower. My last two blog posts have outlined how the Fed's stealth stimulus will keep real rates low and give the economy a small push in the short run. Although the stealth stimulus should support U.S. equity prices, the same cannot be said for its effects on Treasurys.

 

The end of the $600 billion money-printing operation, bubbling inflation pressures and the government's struggles with the debt ceiling are the three main reasons Treasurys are set for a decline in the coming weeks. Currency effects from a strengthening euro, due to interest rate hikes from the European Central Bank, will also weigh on T-bonds.

 

The Fed will end most of its purchases of Treasurys this month as QE2 ends. This will result in a dip in demand, ultimately reducing prices in the open market. Without the Fed's support, it will take time for banks and foreign investors to fill the void in demand. With a QE3 off the table, look for prices to drop until the market is able to correct for this.

 

Societe Generale economist Aneta Markowska worries that Treasury auctions will become more volatile as the Fed steps back -- causing investors to demand higher yields in exchange for the added risk. The chart above shows the task that lies ahead for the market as it makes up for the lost buying power of QE2.

 

While investors have been able to prepare for the end of QE2, the problem with inflation has only recently crept back into the picture. With the Fed's stealth stimulus keeping real rates in negative territory, inflationary pressures will only build as growth revs up again. This is bad news for bondholders, as inflation erodes away the value of future interest and principle payments. 

 

Finally, with Democrats and Republicans still far apart on the actions needed to quell the debt problem, it's likely that the Treasury will come very close to its Aug. 2 deadline. The two parties ran the clock out back in April on the 2011 budget, which resulted in a short shutdown of the government. Similar brinkmanship is likely to seen again. 

 

 

Tom McClellan of the McClellan Market Report is beginning to see a shift in sentiment among investors as they begin to discount all of these factors. Right now, commercial traders (the "smart money") are moving into their most negative stance on T-bonds since the highs seen last fall. At the same time, retail investors have flooded into T-bond ETFs like the iShares 7-10 Year T-Bond ETF (IEF) at a pace normally seen near meaningful tops for Treasury prices.

 

Technically, a breakdown seems to be in motion now after a poor 30-year bond auction on Thursday. The iShares 20+ Year Treasury Bond ETF (TLT) has formed a "bearish engulfing" pattern and looks ready to head lower.

 

I've recommended my newsletter subscribers take advantage with the leveraged Proshares UltraShort 20+ Year Treasury (TBT), which returns twice the inverse daily return of long-term Treasury bonds and was selected with the help of technical screens developed with Fidelity's Wealth Lab Pro back testing toolset which you can find here. (Editor's note: Fidelity sponsors the Investor Pro section on MSN Money.)

 

Disclosure: Anthony has recommended TBT to his newsletter subscribers.

 

Check out his new investment advisory service, The Edge. A two-week free trial has been extended to MSN Money readers. Click here to sign up.

 

The author can be contacted at anthony@edgeletter.com and followed on Twitter at @EdgeLetter. Feel free to comment below.

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8Comments
Jun 9, 2011 5:50PM
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Your charts and graphs are very very pretty. But they do not speak for the people on the street with common sense.  I can put on a chart to say whatever I want it to say and then rationalize it based on my agenda or gut-feel.  Bonds will continue to be a safe haven no matter how dumb our government is. Why? At this point what are the alternatives? You either buy bonds or believe the entire system is ready to come crashing down. If it does, does it really matter? At least you know who to go after to get your money back.

 

Steve Phillips, Cincy, Ohio

Jun 9, 2011 10:18PM
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America is continuing to try to make socialism work, so there's no real reason to think the future is bright.  When Obamacare starts, it will sink the economy even further.  It's good to think and plan ahead!
Jun 9, 2011 6:25PM
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With any luck, the government will default on its obligations, the pblic will wake up from its coma and we can start over again.  The problem is that the public today is far less intelligent than it was in 1791, so I am not confident in what a new constittional convention would produce.

 

Jun 10, 2011 9:53AM
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Bonds will continue to be a safe haven no matter how dumb our government is.

Anthony's point is in the short term there's about to be a lot less demand. Period.

 

You can't just remove 600 billion of buying support from the system and expect the TLT to stay at it's elevated price. Which is hugely above it's moving average. Who is going to replace 600 billion in bond demand in the short term? No one.

 

Inflation also has the power to destroy bond prices. Very quickly. And in general inflation is picking up speed even here in the US. But it definitely is globally.

Jun 10, 2011 6:15PM
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I'm investing in silver and gold.....The biggest piece of garbage to invest in is the fedDevil.
Jun 10, 2011 8:19AM
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You missed a major T-Bond Customer group, the average American investor. U.S. demogaphics favor Bond vs. equity investing at this time. Most Boomers are now either at or are getting close to retirement age when secure income beomes more important than risk. Smart investors will diversify their Bond and Equity portfolios which in most cases will include T-Bonds for Safety. Suggesting that the U.S. government is so dysfunctional that it may default on it's Bonds is irresponsible, in my opinion. You obviously never heard of one of the most universal of all investing rules --- "Don't fight the Fed"    

Jun 10, 2011 10:25AM
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You missed a major T-Bond Customer group, the average American investor. U.S. demogaphics favor Bond vs. equity investing at this time. Most Boomers are now either at or are getting close to retirement age when secure income beomes more important than risk. Smart investors will diversify their Bond and Equity portfolios which in most cases will include T-Bonds for Safety. Suggesting that the U.S. government is so dysfunctional that it may default on it's Bonds is irresponsible, in my opinion. You obviously never heard of one of the most universal of all investing rules --- "Don't fight the Fed"   

Ummmmm....isn't that anthony's point?

 

The Fed is ending QE2. And if you've seen the recent statements out of the Fed, they are making it read between the lines clear there's not going to be any QE3 in the near term.

 

No amount of boomers retiring this year is going to make up 600 billion lost in bond stimulus. Let alone that most people proceeding to that age have already rotated steadily to cash and bonds, so you're not going to see much influx that wasn't already there.

 

If you take all 80 million boomers X 150k you get 12 trillion in average 401k money. The ages of boomers are approx 50 to 67. Given that, the average 50 year old is already at 25 or 30% allocation of cash and bonds. The max allocation generally is around 50% because you still need growth during retirement to keep funds level.

 

So let's assume even 20 years, at 1% switch to bonds (and cash, not just bonds) a year to hit 50% by SS age. So let's say you have all 80 million switching 1% of their 150k average 401ks over to bonds (and it's not all bonds, cash is not bonds).

 

That's $12 billion dollars a year. 1,500 dollars X 80 million. 12 billion does not equal 600 billion. 600 billion lost in momentum is going to be hard to deal with.

Jun 9, 2011 6:47PM
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If my stocks take a beating, if interest rates rise, if the economy tanks, I am GOING to blame the Republicans for playing chicken rather than fighting their fight honestly.  They said they have as their one goal to defeat President Obama.  This is a goal they are willing to do anything for, including hurt millions of Americans.  They already ruined the American economy once.  Fool me once, shame on me, fool me twice, shame on the GOP.
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