Thursday, June 3, 2010

Shorting Treasurys In Anticipation of Inflation: Harder Than It Seems

One of the “slam dunk” trades for the inflationist camp has been to short treasury bonds, especially the long ones. On the surface, it makes perfect sense: a fixed income instrument should decline in value when rates rise. Notwithstanding the recent gains in T-prices, along with the commensurate pain for the shorts, this trade is much less of a slam dunk than it appears. Here are my views on why it will be a while before the short LT treasurys trade works the way it is supposed to.

First, interest rates in general. A bond short can be based on two views. One is credit quality, the other one is a view on rates. Credit quality (i.e. getting paid back as contracted) would be a problem for the US if we were not borrowing in a currency we do not control. For now, we can get away with both taking the loans out and keeping the printing press, and this privilege has been recklessly abused. In other words, the US government will almost certainly take the easy road of printing rather than the harder road of actually paying down the debt. So if there are no nominal credit problems, this leaves rates. Normally, the central bank/s raise rates when inflation picks up in order to cool off demand/growth, generally believed to be the driving factors behind inflation (a misguided, incomplete view, but this is another topic). When rates rise, bond prices fall. Longer duration bonds drop more for the same increase in rates. But my problem with this is that the interest rates are one of the most managed (manipulated, if you prefer the conspiracy lingo) aspects of the economy. There are very strong incentives besides steroid-based economic growth for low rates, namely the cost of government borrowing and bank profitability. The Fed is not really independent, and Zimbabwe Ben has this moniker for a reason, so you can be almost sure that headline rates will be managed to stay low by all means necessary.

Second, in-built structural demand and potential new (!) demand. Do not forget that there is substantial built-in demand for treasurys from a number of market participants. Since bonds mature, there is a ready roll-over market. If bond fund flows increase (which could be just a function of increased retirement savings contributions in target-date plans), this creates additional demand. Pension plans, endowments and so on have pre-set government bond allocations, and the simple act of portfolio rebalancing can increase the demand for treasurys. Then you have insurance companies that are subject to rigid portfolio holding regulations, as well as to liability matching (which is done via longer-term treasurys). I am sure that there are more examples. Finally, you have “your” politicians “working” hard to “protect” your retirement savings from the evils of the stock market, so do not be surprised if there is an Argentinean-style theft of the 401k/IRA balances to be put in treasurys (or removal of their tax status, unless they invest in Ts). This can be in addition to new, mandatory employer retirement contributions to all employees (de facto, an employment tax) that automatically goes into Ts unless otherwise specified by the employee.

Third, a possible slow-down in new supply. Despite Washington’s best attempts to saddle the economy with a whole new round of structural problems (healthcare “reform”, “climate” bill, financial “reform”, idiotic stimuli programs, etc.), the economy and the tax base may begin creeping back up, surprising everyone. Some of it might be natural, some of it might be due to some productivity breakthroughs, some might be due to baby boomers working much longer than anticipated, or withdrawals from the cesspools that Bush got us in and so on. This will reduce the supply of new paper (the rollover requirements will stay, have no illusions, the national debt cannot be paid off, let alone the unfunded liabilities). But shorter term, lower funding requirements for admitted tax cheat Turbo Tim might end up putting a lid on the yields.

Finally, the coupon. Don’t forget that the bond is a contractually yielding instrument. So in effect, you are already swimming against the tide to begin with, hoping that the rates move down enough to beat the coupon pass-on, and then cover the opportunity cost of the position.

Frankly, I am as bearish as anyone, may be even more, regarding long-term government finances/demographics/entitlements/etc. I am just afraid that there are too many tricks in the bag left to keep the government borrowing costs low. A few weeks ago I closed out of TBT (2x inverse LT Ts) at a small profit, and I do not foresee re-entering the trade any time soon (and if I do, it would not be with TBT for sure)..

No comments: