Why I'm So Aggressively Shorting Bonds
"I think there are gonna be history books written about this period that rational people will read at some point, [and] they are gonna ask this question of economic historians with complete bewilderment in their voice:
'Professor Jones, did investors REALLY invest in bonds of basically bankrupt countries that printed money to make interest payments and [buy back] bonds they just issued in failing currencies? ... Were investors really that stupid?'"
-- Subscriber 'BadGolfer,' as quoted in Doug's Daily Diary, Introducing Subscriber Post of the Week! (April 15, 2016)
As I've noted in the past, the 10-year U.S. Treasury yield has approximately equaled 0.9x to 1x of the U.S. nominal growth rate (real gross-domestic-product growth plus inflation) over the past five decades.
Let's assume that this historical relationship still holds true, and that America is seeing roughly 1.5% to 2% real GDP growth and a 1% to 1.5% inflation rate. That equates to 2.5% to 3.5% nominal GDP growth.
Under this scenario, history would indicate that the 10-year Treasury yield should be about 2.85% -- or 136 basis points higher than the roughly 1.49% that we're seeing this morning. Even if we assume that this relationship should move down to a more conservative 0.7x, the 10-year yield should still be at 2.10%, or 61 basis points above current levels.
Now, there are several reasons why investors are attracted to a 1.49% 10-year Treasury yield even though that equates to only about 0.5x nominal GDP vs. the historically normal level of approximately 0.95x. Let's check these out:
ZIRP, QE and ECB Bond Buying
The Federal Reserve's Zero Interest Rate Policy and three rounds of Quantitative Easing have been anchors to our low interest rates in recent years. So has the notion of secular economic stagnation.
But many are convinced that the negative interest rates that we're seeing in Europe and elsewhere (caused in a large measure by European Central Bank bond buying) are an even more potent reason why U.S. interest rates are so low.
Some investors argue that U.S. Treasuries are attractive because they provide relatively strong returns compared to other geographies. For example, to 10-year Treasury's 1.49% yield handily beats the 10-year German bund's roughly -0.12% current payout.
But to me, the concept of relative value between investments is a greatly overrated, and at times even absurd. (See Badgolfer's quote at the beginning of this column.)
This seems to me to be true when some investors call Treasury bonds "attractive." To say the 10-year Treasury's low yield is attractive vs. the 10-year bund's negative one is like saying that New York Yankees DH Alex Rodriguez is attractive because he's hitting .220 when first-baseman Mark Teixeira is only hitting .190. In reality, both stink.
T.I.N.A. Is B.S.
I also reject the idea that stocks are "attractive" because they're cheap relative to bonds right now.
This is known as "T.I.N.A." -- "There Is No Alternative" to stocks -- but I don't buy it. If bonds are overvalued, where does that leave stocks?
Or how about another "relative" notion -- that U.S. stocks are the "best house in a bad neighborhood" when compared to foreign equities? If non-U.S. economies are problematic and their share prices vulnerable, I think that argument holds little water in our flat and interconnected global economy.
The Bottom Line
Grandma Koufax summarized the fallacy of "relative concept" best when she used to tell me: "Dougie, two wrongs don't make a right."
Stated simply, I believe that fixed-income markets around the world are in a bubble of monumental proportions -- and as is the case with most bubbles, the irrational is being rationalized.
That's why I've chosen to short bonds. I recently made a long of the ProShares UltraShort 20+ Year Treasury (TBT) -- a 2x inverse play on the Barclays U.S. 20+ Year Treasury Bond Index -- our Trade of the Week. I also put the iShares 20+ Year Treasury Bond ETF (TLT) on my "Best Short Ideas" list yesterday.
Of course, using leveraged ETFs like TBT as a Trade of the Week is all in the timing. But I'm basing my near-term optimism for this trade in part on the fact the despite the global economy's recent chaos, commodity prices continue to act well. For example, copper was at a two-month high at last check.
And while it should be clear from the points above that I like shorting European bonds even more than U.S. ones, I know the average U.S. investor doesn't have the ability to short foreign debt.
Still, I can say with a high degree of probability that when this whole bond bubble blows up, it will wipe out years of profits for many!