Bonds: Treasury Yields Still Too Low

Introduction

Since I wrote the last bond post update back in late November of 2011 (Article: Treasuries Sentiment Extremely Bullish), the 30 Yr Treasury Long Bond price has just moved sideways. My advice back on 22nd of November was as follows:

"...buying Treasury Bonds would be the last thing on my mind. Holding cash is where I am overweight right now, however in Australia we earn 6% interest on our high cash hoard. So therefore, personally, our fund is getting ready to allocate funds to commodities, which we believe are extremely oversold in recent weeks - especially Agriculture. So therefore in summary, I'll keep it simple: short Treasuries, buy Commodities!"

Where I was right is essentially in the outlook that buying Bonds was a mistake, despite awful economic news around the world, including Europe being on fire. Looking back, we can safety say that Treasuries have not created any capital gain since that post. However, I also haven't been right in predicting a decline in bond prices / rise in yields so far either. At best one would have broke even if you shorted the TLT ETF. Do keep in mind that sideway movements do not last forever, so what is next for the government bond market?

Risk Overbought From Short Term

I still maintain my bearish stance on Treasury Bonds, however the overall macro condition has changed a bit in the last couple of months. As you may recall, S&P 500 was quite oversold in late November, so an equity rally and a Treasury sell off made sense. Fast forward to today and while Treasury Bonds are still extremely overbought from the long term perspective, equities have also become overbought from the short term perspective in recent weeks too (Article: Possibility Of A Correction Approaching).

It is safe to say that, while Treasuries have gone sideways for a good few months, equities have staged an impressive rally from 04th of October at around 1075, towards 1,333 in recent days. A move like that makes me think equities are now overvalued relative to bonds over the short term. Furthermore, certain basket of commodities like Crude Oil, Heating Oil, Gasoline, Gold, Silver, Platinum and even Copper have become somewhat overbought from the short term perspective as well. Article I recently read on Bloomberg, stated that equities around the world are off to the best start in 18 years. Dow Jones has posted the best January gain since at least 1997. That type of a move is usually not sustainable on annualised basis and begs for a pullback. On top of that commodities like Crude Oil and Platinum created bearish reversals last night in US trade.

Therefore, it shouldn't be difficult to envision a scenario where risk assets like equities and certain commodities correct for several days or weeks working off recent gains. At the same time, the 30 Yr Treasury Long Bond could benefit under this scenario, where the price could make a break out on the upside. However, I do not think this technical move will be real or sustainable, but rather could turn into a bull trap.

Bonds Overbought From Long Term

The reason I hold this view is because nothing dramatic has changed since late November 2011. As a matter of fact, a further move up above 146 on the Long Bond futures will only make the asset class more overbought from the long term perspective and turn me even more bearish on the asset. One of the reasons Treasuries could be rallying in recent days is most likely linked towards Bernanke's push towards QE3. Therefore, constant arguments by perma bears that Treasuries are pricing in deflation is total non sense.

Official CPI figures are still over 3% [note: who is going to believe that?], while old metrics range from 6% to 10% inflation in the US. Furthermore, CPI tends to follow commodity prices and with the US Dollar putting in a potential top in recent weeks (Article: Dollar Rally Ending Part I & Part II), commodities should do quite well in the in 2012. Therefore, I would expect rising inflation in coming quarters, which builds further case to sell Treasuries.

But our perma deflationist friends would not believe one word of what I stated here. They seem to be blind to the way wise greedy bankers are front running the Fed's actions as they wait for Chairman Bernanke to take Treasuries of their hands in a form of QE3 at higher prices for a nice profit. In purest form, this is money printing to repair / bail-out balance sheets of US financial institutions, similar to what LTRO is doing in EU. Therefore, in due time, I would expect majority of Treasuries that have been bought all throughout the fearful days of 2011 - as we watched Italy and Europe almost fall of the cliff - to be offloaded back to the Fed. As QE3 comes, yields should once again start to rise in a trade formally known as "reflation" or "risk-on".

Furthermore, it is not only Treasuries that are overbought. German Bunds, Japanese Government Bonds (JGBs) and United Kingdom Gilts also fall into the same category. One thing I found interesting is that while the 10 Yr Treasury Note, Bund and Gilt made all time new lows in yields, Japanese Bonds failed to do so. Are investors finally realising Japanese debt problems are even worse than those of Europe, as Kyle Bass has been warning us for a long time already? For those that have the facilities to do so, should definitely consider betting against JGBs in due time as they seem relatively weak compared to other bonds at present. Investors should also pay close attention to the Japanese Yen, which has been strengthening for over four years now.

Summary

Since I turned bearish on Government Bonds in late November 2011, I have not been right as of yet. Treasuries have been moving sideways and are now threatening to break to the upside as stocks and commodities experience a potential correction. Having said that, it is my belief that this move, if it occurs, will prove to be short lived and essentially will trap a lot of bond bull Johnny Come Lately's. I still hold a view that one of the main surprises of the 2012 will be the rise in yields on government bonds, including 10 Yr Treasury yields to rise above 3%. Those bearish on bonds should pay close attention to Japanese Government Bonds (JGBs) in particular, as very rewardable shorting opportunities exist there.

As always discussions and comments are welcome. Do tell me what you think...