I shorted 10 year treasuries today, as mentioned in an earlier post; and there’s a good chance that I’m early, also discussed. I decided to share some of the thought process, if not all the financial assumptions, because I received a lot of questions on the post.
Since some of the comments had similar themes, I’ll combine and paraphrase:
Is shorting treasuries an inflationary position?
The answer is a definite maybe. Historically, the thinking has been as inflation goes up, interest rates will rise and treasury prices will fall. Makes sense. The real issue is one of causality. It’s true that inflation might cause rates to rise, but so could other things (for example, China not showing up for an auction).
Is shorting treasuries a risk trade?
This series of questions revolved around the belief that the run-up in treasuries was a manifestation of risk being taken off the table. Agreed. But at some point, being long treasuries becomes its own manifestation of the risk trade. Locking in 3.2% (or less) for 10 years seems pretty risky to me in an environment of increased quantitative easing, increased taxes, slower growth, etc. Some of the comments suggested that instead of shorting treasuries, I should go long equities as a better expression of the risk trade. If that was the trade, I’d agree, but I believe there is a strong chance that we can have slower growth AND higher long term rates.
What are possible scenarios where we could see treasuries fall AND equities head lower?
Stocks and bonds might have low correlation on a short term basis, but on a longer term basis, equities had their biggest bull market run from the early 1980′s through 1999/2000 – a twenty year bull market. Simultaneously (correlation or causation?), interest rates went from 17+% down to 3+% in the greatest bond bull market in history. Looking forward, why wouldn’t we expect their bear markets to coincide as well? Asset allocation works well as long as assets aren’t correlated, yet throughout the investing public’s experience, all asset classes that they invested in (stocks, bonds, real estate being the major ones) went up. So one scenario is just a simple correlation without trying to explain the cause, but we can do better.
Digging deeper, let’s examine the famous deflationary argument (to which I happen to ascribe). Deflation is the ultimate fear trade. Investors get scared of holding long term investments and begin hoarding shorter term investments, ultimately preferring cash to pretty much everything else. There are a few commodities that end up being safe havens in deflationary environments (gold, perishable foodstuffs, etc.), but financial assets as a whole are not them. On a valuation perspective, if companies lose pricing power, margins erode, people spend less, and people have less money that they are willing to invest/lend believing that by waiting things might go on sale. So stocks go down. At the same time, governments are forced to pump ever increasing amounts of stimulus and spend increasing amounts on social services. How? Well, they print more and they borrow more, thereby increasing the supply of treasuries available. You get the picture.
But let’s assume you don’t believe we’re going that route. Here’s what really took me over the edge as I started looking at the different scenarios: China, Japan, and the Middle East. My argument is that being long treasuries is being long China, Japan, and the Middle East – none of which I want to be long. Let’s take China as the poster child. Equities are in a bear market. Social unrest is always a risk. Rural/urban disparity continues to worry those in power and the overcapacity built over the past 10 years is unprofitable. At the same time, their biggest trading partner, Europe, is facing its own problems and slower growth, rendering its investments in infrastructure, capacity, and stashes of commodities foolish (at best). And oh yeah, their surplus is concentrated in US treasuries, with the risk that Bernanke & Co. will inflate their deficits away. What’s a bureaucrat to do? One day (I believe soon), there will be a failed auction. By failed I don’t mean that the Chinese (or Japanese or Middle East block) won’t show up at all, just that they won’t bid aggressively, they won’t take down as much, or they won’t take down the long end. Guess what, they need to spend that money domestically, not lend it to the US so that we can lend it to Greece. No inflationary pressures, just fewer bids. A scary proposition and a huge game theory nightmare since all the other players will have to scramble to front run each other. FUBAR.
I’m probably early in my assessment, and treasuries might still be the safe haven trade tomorrow, and later in the week, as we get more auctions, everyone will show up as usual. However, the scenarios are real, and if nothing else, pose a serious risk to those who chose to use longer term treasuries to lock in 3+% for the next 10 years.
For reference and for those who like charts:
Fixed Income/Bonds | Yaron Sadan | 
June 21, 2010 2:34 pm | 
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