Bond Bear Re-Load

Yesterday and today I’ve been re-loading the shares of TBT that were called away on the last option cycle.  I’m not writing new calls on these just yet, because I expect the long end of the curve to back off a bit once the excitement about QE2 fades a bit.

The auction of the 5-yr Note was a real surprise to stock market bulls yesterday.  Oversubscription and a 1.25% coupon was as negative on economic growth and inflation as anything we’ve seen since the depths of the panic in 2008 and early 2009.

For those who don’t pay attention to bonds, this is what they were telling you:

Debt deflation is very much alive, and it has the potential to overwhelm any kind of emerging market demand and commodity inflation for several years.  People with serious money don’t commit their cash to a five-year (semi-annual) return of just 1.25% unless they truly believe their money is not safe elsewhere, and that they’ll be happy having less than $1.10 for each of today’s dollars when they look back at their decision in 2015.  They committed billions to this position yesterday, so I would take it seriously.

Does that mean commodity inflation has no effect?


It just means there is a group of people with real money who think that commodity inflation won’t be enough to affect fixed income financial assets until much later — 2016 and beyond.

I come out somewhere in the middle on this inflation/deflation debate.  I acknowledge the rising Chinese and Indian middle classes, and the resulting inflationary pressures on both soft and hard commodities.  I also acknowledge the need to de-lever the world financial system over time, and the implication that this will take another five years or more.

Having been in an institutional commodity sales position back in 1974 and 1975, I can tell you that when fundamental commodities (in that case, oil) suddenly move upward, that it takes a couple of years for that inflation to ripple through everything else.  It doesn’t happen overnight.  For example, fully two years after the oil price shock from the 1973 OPEC embargo, I was dealing with monthly price increases on paper stock (which used energy to dry and a lot of transportation) and industrial perfumes (which were an expensive part of every floor cleaner, disinfectant and hand cleaner).  Same with plastics.  It took nearly three years for all the price increases to ripple through the system.

I expect we’ll see a similar path now, with the inflationists ever more frustrated as their bearish bets on the Dollar, gold speculation, etc. show a profit, but don’t reward them with the retirement bonanza they think will happen.  On the other hand, years of steady price pressure on basic commodities will get “stored” as potential financial inflation ready to emerge once the debt-deflation is finished, since our household and financial institution delevering won’t change the supply/demand picture in Mumbai or Shenzhen.

When the debt liquidation delevering loses its ability to offset the commodity deflation, then we’ll experience a round of inflation in the US that will decimate bond holders and reward commodity investors.  Right now, it looks to me that a ten-year horizon is a safe bet for that particular ship to come in.  That’s why I think 2.50% on the ten-year Treasury will be the approximate bottom.

I’m holding levered ETF’s that short the long end of the yield curve.  I think of the ten-year as the likely pivot point for this battle of Titans, where bearish and bullish influences are balanced (today), and where the bears will eventually win out.  Put another way, if I imagine a long-term graph of the yield on 10-year Treasuries when we look at it years in the future, I expect we’ll say that it looked like 2.50% was as low as went, ignoring little panic spikes driven by short-term news events.

Even with the Fed in the game threatening to buy every bond in the market to keep rates down, they also need to keep longer term rates up.  The worst possible outcome for them wouldn’t be inflation, but persistent and pernicious deflation.

We have to bear in mind that monetary policy vs. inflation is a peculiar tool.  After all, the cost of money is a key ingredient in any business, so raising rates is actually an inflationary pressure.  That seems to be ignored by those who blithely accept the idea that Volker’s high-teens Fed Funds rates broke the back of inflation (that same inflation that continued to reverberate through the economy from the oil price shock of 73/74).

High rates didn’t break inflation, the early 80’s double recessions did.  Demand fell.  Capital was so expensive that people chose not to invest or spend.  Volker’s rate hikes caused the recession, which in turn removed the demand that was driving inflation.  If people had basically decided to pass through the additional costs of capital the way they passed through the additional costs of oil, the outcome might have been very different.

Now we’re on the other end of the scale, where lower rates don’t seem able to drive any additional demand.  The classic deflationary trap.

Bernanke is aware of this, so his purchases of Treasuries won’t push the rate on longer bonds so far south that cost of long-term money becomes yet another deflationary element.  He needs it to be slightly inflationary.

To me, 2.50% looks like as good a place as any, so I’ll keep buying TBT and TMV, but also keep selling covered calls, because years take a long time to pass.



4 Responses to Bond Bear Re-Load

  1. William Kinsolving says:

    So why not buy gold? Or is that one of the commodities of which you speak?


    • hhill51 says:

      I think gold is in a long-term bull market, but I don’t buy into the collapse of all fiat currencies, $10,000 an ounce arguments, at least not for years from today.
      Then there is the auto-correlation that occurs in major bear market panics. If gold is doing well, some percentage of the traders holding other distressed assets will sell their gold to meet capital calls, so the likely result of panic selling in stocks or bonds is to have gold take a sickening dip in price, even if it is temporary.
      That said, I picked up a chunk of speculative gold shares suggested by my cyber-buddy Moriarty (, and was happy to have them these past few months. Last week I sold enough shares to own the rump position at a lower cost than the profits already realized (now playing with “house money”).

  2. jill says:

    On the original Treasury QE announcement of March 18, 2009, the 10 year yield dropped 55 basis points to 2.47%. Over the next three months It reached a high of 4.01%.

    We are at 2.52% today. What are your expectations on the ten year yoeld when QE2 is announced?

    • hhill51 says:

      Hi, Jill —
      Good work pointing out the pattern following the QE I announcement. I look at it like the famous “October surprise” when Treasury suddenly stopped issuing long Bonds. There was a short-covering scramble and a rush to fill portfolio duration needs. It was appropriately named a surprise. Same with QE I, IMO.
      I just don’t think QE 2 can be a surprise. I think it’s more likely that a daily trading rally could push 10-yr Notes down for at most a day or three, and then fundamental issues of twin deficits (trade and budget) will have their effect. The potential for lower rates is why I’m only scaling in to the bearish position, and also why last month and this month I will look at selling near out-of-the money calls on the TBT I buy. It has enough liquidity and liquid enough options to play that way, but TMV doesn’t, so positions in that one will be undhedged.
      If we were to repeat the pattern you point out from QE I, I’ll keep adding to the position during a bond rally, even getting overweight if we flirt with 2% yield on the 10-yr.
      If that scenario were to play out, then my “starter” position will be underwater for a while, but profitable within a few months, and the add-ons would make a fortune.

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