March 30, 2012

This Safe Haven Could Tank 18% in the Next Two Months

By Louis Basenese of Wall Street Daily 

By now you’d expect that every investor is preparing for a selloff in long-term bonds. After all, the Fed can’t keep interest rates near 0% forever.

Unfortunately, though, such expectations don’t entirely match reality.

Based on the latest fund flow data from Lipper Research, many investors remain enamored with long-term bonds.
In February, they plowed another $30.9 billion into bond funds, the largest monthly inflow since August 2010. And of that amount, $15.8 billion (or about 50%) went into long-term bond funds.

But not every investor is clueless.

On Monday, fund flow data company, EPFR Global, revealed that for the week ending March 23, investors yanked $1.01 billion out of the most vulnerable bonds: U.S. Treasuries.

That’s the biggest weekly outflow on record and a clear reversal in recent fund flow trends. But it’s a trend I expect to accelerate in the weeks ahead.

In fact, I’m convinced we’re on the cusp of a massive exodus out of U.S. Treasury bonds. And any investors still treating such bonds as a safe investment could be in store for a very nasty – and costly – surprise…

This Treasury Selloff Has Legs

Since peaking on December 19, 2011, Treasury bond prices are down 8.8%, based on the iShares Barclays 20+ Year Treasury Bond Fund (NYSE: TLT).

That might not seem like a lot. But we’re talking about bonds here. Such “safe” investments aren’t supposed to drop that much in three months’ time. Or are they?

If we look at the five-year price chart for Treasury bonds, it turns out a clear pattern emerges. Ever since the financial crisis hit, sudden and swift price drops are the norm.

Take a look:



From December 15, 2008 to June 1, 2009 – a period of 166 days – Treasury bonds dropped 26.4%.
Then, from August 10, 2010 to January 31, 2011 – a period of 165 days – Treasury prices dropped 16.2%.
If we use these two corrections as a historical guide, the current selloff could last another 67 days and lead to an additional 17.6% decline in prices.

If we take into account other factors, the current selloff could prove to be much worse. And here’s why…

The Market, Not the Fed, Will Raise Interest Rates

Yesterday I noted that the U.S. economy “appears to be picking up steam.” And here’s proof from Bespoke Investment Group to back me up…

The firm’s Economic Indicator Diffusion Index, which tracks the number of reports coming in ahead of expectations, has been positive for 100 trading days. That’s the longest streak since 2009.

So even after months of stronger-than-expected reports, “Economists are still behind the curve in ratcheting up their forecasts to what is actually transpiring in the economy,” says Bespoke.

The implications in terms of the Treasury bond market can’t be ignored. Put simply, if the trend of better-than-expected economic reports continues, the Fed should be able to raise interest rates earlier than 2014.

I’m not alone in this thinking, either. Scott Minerd, of Guggenheim Partners, believes an improving economy could put upward pressure on interest rates in the next six to 12 months.

In other words, we won’t need an official raise from the Fed before the market reacts. Once it’s clear that the U.S. economy is out of the woods, the market’s going to price in an interest rate hike. Immediately. And once that happens, Treasury bond prices are bound to fall, much harder and much faster.

If you’re reluctant to embrace the improving economic picture in the United States because of the threats posed by ongoing financial issues in Europe and an apparent slowdown in China, chew on this: The U.S. GDP isn’t overly reliant on either.

Exports to Europe only account for about 2% of total U.S. GDP, whereas exports to China account for less than 1%.

Even if you don’t put complete faith in an economic recovery in the United States, you can’t ignore the tale of the tape. The Treasury bond market appears poised to roll over. Just like it’s done two other times in the last five years. So make sure you don’t own only long-dated Treasury bonds.

If you want to try to profit from this situation, do so carefully. I say that because our trading options are less than compelling…

If we sell short the iShares Barclays 20+ Year Treasury Bond Fund we’re responsible for covering the monthly dividend payments. And the more time that passes, the more the payments will eat into our potential profits.
Buying long-dated put options on TLT isn’t a particularly wise choice, either. Current premiums are way too expensive.

Another option is an inverse fund, which goes up in price as Treasury bonds fall in price. But most such funds use leverage and rebalance daily, which can lead to undesirable trading results.

Bottom line: Although investing in long-term bonds – specifically, U.S. Treasuries – might seem safe and comfortable right now, it’s anything but. Or as Robert Arnott said, “In investing, what is comfortable is rarely profitable.” So hurry up and sell out of Treasuries before it’s too late.


Courtesy  Louis Basenese  at Wall Street Daily (EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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