Bond Prices Spike

I entered a paired trade in February where I went long short-term corporate bonds and shorted long-term government bonds. This has been doing pretty well so far. Over the past two days however, Treasuries have spiked. Ouch! Check out this interesting article about treasury prices in the latest issue of Barrons.

Treasury Yields Leap to Fair Value
By RANDALL W. FORSYTH

THIS HAS BEEN THE WORST TREASURY bond market ever, at least by some measures. Yet, the reasons aren't what you hear from the Howard Beale-style rants from Chicago futures pits.

While there are legitimate reasons for concern about the Treasury's trillion-dollar borrowing needs, the reluctance of creditor nations to accommodate them and the Federal Reserve's money printing, the recent back-up in yields largely reflects other, less fundamental reasons.

From a hair over 2% at the beginning of the year, the benchmark 10-year Treasury yield surged to a high of 3.70% Wednesday. And the 30-year long bond vaulted more than two full percentage points from their December lows to 4.63% Wednesday.

That doesn't sound like much except to bond geeks, but in price terms, the iShares Barclays 20+ Year Treasury Bond exchange-traded fund (ticker: TLT) lost 25% of its value over that time. That was nearly as big as the plunge in Dow Jones Industrial Average from the turn of the year to its early March lows.

What's extraordinary is that this jump in long-term bond yields came as the Fed pinned its federal-funds rate target at close to zero. Other back-ups in bond yields came when the market anticipated future hikes in the overnight rate, but the Fed has made it clear it will hold its funds rate target at virtually nil for as long as it takes to jump-start the economy.

Moreover, on March 18, the central bank said it would buy an additional $1 trillion of U.S. agency debt, agency mortgage-backed securities and Treasuries to push longer-term rates down to lower borrowing costs, in particular on mortgages.

That clearly hasn't happened; just the opposite. The Treasury yield curve (typically described as the difference between the two- and 10-year note) steepened to a record 2.77 percentage points Wednesday, according to Stone & McCarthy Research Associates.

Part of the back-up reflects the low absolute level of rates earlier this year. Indeed, 10-year Treasury notes yielding only 2% -- as they were around the turn of the year—were attractive only relative to other assets that were collapsing under fear of an economic apocalypse.

With disaster averted and the sighting of the so-called green shoots of growth, stocks had a bungee-jump rebound from their previous nosedive. And low-yielding Treasury notes, which were clutched as life preservers in the storm, were cast off.

But, contends Lacy Hunt, chief economist of Hoisington Investment Management, an Austin, Texas, manager of $4 billion in assets, "The sharp rise in Treasury yields is not a result of an economic recovery. That occurs when income, production, employment and sales, simultaneously, turn higher. Presently, these indicators merely show a lessened rate of decline."

Nor can the burgeoning Treasury borrowing needs fully account for the rise in yield. The ratio of government debt to gross domestic product showed massive increases in the U.S. during the 1930s and 1940s and in Japan since the 1990s, yet yields continued to decline. Indeed, Hunt argues, the shift in productive resources to the government sector from the private sector doesn't stimulate but stymies economic growth.

Finally, the Fed's expansion of its balance sheet doesn't translate into monetary stimulus if the liquidity merely increases excess reserves in the banking system or increases sterile holdings of money balances. Bank credit continues to contract sharply, Hunt points out.

So, what's to account for the sharp rise in Treasury bond yields? Blame it on the intricacies of the mortgage market.

There's a reason that Wall Street hired "rocket scientists" with math PhDs to analyze mortgages. The ability of homeowners to pay off home loans with little or no penalty makes them devilishly difficult to figure out, unlike bonds that commit the borrower to a fixed repayment schedule. Obviously, homeowners will repay or refinance when it's most advantageous for them, which is the worst time for investors in mortgages.

To offset this problem, they hedge with noncallable Treasuries -- buying when they brace for a wave of refinancings and selling when rates rise. Refinancings leave investors with short-term securities when rates fall—exactly what they don't want. Conversely, rising rates encourage homeowners to hang onto their low-cost loans, resulting in the lengthening of the maturity for investors -- again, the last thing they want..

While mortgage investors previously had bought non-callable Treasuries to offset the risk of their mortgages, mortgage investors have unwound that hedge, selling their Treasuries.

This sounds like so much inside baseball but it amounts to huge sums. According to an estimate by mortgage-securities-market veteran Alan Boyce, writing for Drobny Global Advisors, these hedge sales are equivalent to issuance of $1.1 trillion (with a "T") of 10-year Treasury notes, compared to expected sales of $250 billion of that maturity this year.

Clearly, Treasuries were in a bubble when they yielded just 2% for 10 years. Technical factors have nearly doubled that yield from the lows, but not fundamentals -- which still reflect a recessionary economy and debt deflation. As a result, Treasuries are back to fair value for these conditions.

Must Read: You Should Be Petrified

Great video from Howard Davidowitz. He doesn't hold back any punches. If you can't check out the video, which I highly recommend, then here's a brief summary:

The green shoots story took a bit of hit this week between data on April retail sales, weekly jobless claims and foreclosures. But the whole concept of the economy finding its footing was "preposterous" to begin with, says Howard Davidowitz, chairman of Davidowitz & Associates.

"We're in a complete mess and the consumer is smart enough to know it," says Davidowitz, whose firm does consulting for the retail industry. "If the consumer isn't petrified, he or she is a damn fool."

Davidowitz, who is nothing if not opinionated (and colorful), paints a very grim picture: "The worst is yet to come with consumers and banks," he says. "This country is going into a 10-year decline. Living standards will never be the same."

This outlook is based on the following main points:

• With the unemployment rate rising into double digits - and that's not counting the millions of "underemployed" Americans - consumers are hitting the breaks, which is having a huge impact, given consumer spending accounts for about 70% of economic activity.
• Rising unemployment and the $8 trillion negative wealth effect of housing mean more Americans will default on not just mortgages but student loans and auto loans and credit card debt.
• More consumer loan defaults will hit banks, which are also threatened by what Davidowitz calls a "depression" in commercial real estate, noting the recent bankruptcy of General Growth Properties and distressed sales by Developers Diversified and other REITs.

As for all the hullabaloo about the stress tests, he says they were a sham and part of a "con game to get private money to finance these institutions because [Treasury] can't get more money from Congress. It's the ‘greater fool' theory."

"We're now in Barack Obama's world where money goes into the most inefficient parts of the economy and we're bailing everyone out," says Daviowitz, who opposes bailouts for financials and automakers alike. "The bailout money is in the sewer and gone."