Shorting US Treasuries: A High Probability Trade

The famous value investor John B. Templeton coined this rule of thumb, which I live by: “Bull markets are born in pessimism, grow in scepticism, mature in optimism and die in euphoria.”

At present, conditions in the US Treasury market can only be described as “euphoric” with yields on the US 10-year at 60-year lows. Just to clarify how the bond market works: when bond prices go up, yields go down. So this means that prices in the US 10-year bond market are at 60-year highs. If this still does not mean anything to you, then the yield on the US 10-year is almost half (1.94%) of the “official” rate of inflation (3.8%). 

So yields are not keeping up with inflation – the rate at which cash is losing ground in terms of purchasing power. Those investing in the US 10-year treasury bonds are losing about 2% of their wealth each year because of the effects of inflation. Furthermore, about 50% of the stocks in the S&P 500 have dividend yields more than the US 10-year treasury yield. 

I think the US Treasury market is a time bomb just waiting to go off. The collapse in the treasury market could be equally as dramatic as its recent rise. I believe that there are only three plausible economic scenarios that can be reasonably derived from the current state of economic affairs in the US and the world at large. All three outcomes will ultimately result in substantially higher long-term US Treasury yields.

Scenario One: US Economy Recovers 

Long-term treasury yields will rise substantially. Annualised inflation in the US is running at 3.8%. Any economic recovery in the US within a couple of years will probably mean annualised CPI inflation in excess of 3.0%. Economic fundamentals dictate such a result, as well as the current  Federal Reserve policy. The  Federal Reserve policies are aimed at insuring that “core” inflation stays above 2% to protect against any possibility of deflation.

In light of this, 10-year bond yields would certainly rise above 4%. Indeed, there are no historical precedents for the real (inflation-adjusted) rate of return on US Treasuries to be sustained for long periods below 2% in the midst of an economic recovery and relatively low inflation. So 2% real yields plus inflation in the range of 2-4% adds up to yields in the range of 4 to 6% (or more) instead of the current yield, which is close to 2%.

Scenario Two: US Economic Recession and Debt Default

To put it bluntly, the US economy cannot afford a recession. The fiscal deficit is already running at an unsustainably high 8 to 9% of GDP. A recession would cause tax receipts to collapse and cause outlays for automatic spending stabilisers such as unemployment insurance, nutritional support, Medicaid and the like to spike higher. The budget deficit could balloon to an unprecedented 12% of GDP or higher.

This level of budget deficit would be perceived by market participants as being utterly unsustainable and not financeable. Few creditors would lend money to the US Treasury at low rates under these circumstances.

With default risk rising exponentially, yields on long-term Treasuries would tend to spike, much as they did recently in the case of Spain and Italy. Incidentally, it should be noted that both Spain and Italy are currently running much lower budget deficits than that of the US as a  percent of GDP and magnitudes lower as a percentage of total fiscal revenues.

Scenario 3: US Economic Recession Followed by  Federal Reserve-Engineered Inflation

It is extremely unlikely that the US will ever default on its public debt. The reason is simple: the US has a fiat monetary system that can effectively serve as a guarantee that such an outcome never occurs. Indeed, the  Federal Reserve has a legal mandate to promote full employment. Both from a legal and political point of view, the  Federal Reserve cannot sit idly by and allow a deflationary default scenario to transpire since it would probably cause unemployment rates of more than 20% and under employment north of 30%.

Furthermore, ever since the publication of A Monetary History of the United States by Milton Friedman there has been a virtually unanimous consensus among economists and policy makers in the US that it is far preferable for the US to risk inflation through aggressive monetary intervention than to allow another Great Depression. Indeed, Federal Reserve Chairman Ben Bernanke has been widely recognized as proponent of this type of academic and policy opinion during the past decade.

Readers would be well served to peruse Bernanke’s speech entitled, “Deflation: Making Sure that ‘It’ Does Not Happen Here”. In that speech Bernanke made the following unambiguous remarks:

“The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand - a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending - namely, recession, rising unemployment, and financial stress.”

Bernanke then went on to describe a dizzying array of policy options to combat the decline in aggregate spending that is at the root of a deflationary environment. Bernanke discussed a truly fantastic array of options including targeted currency depreciation through purchase of foreign currencies, a “zero interest rate policy”, equity purchases and much more. It makes for fascinating reading – a veritable dystopian brainstorm. However, perhaps the most important and highly revealing remedy that Bernanke discussed was the following:

“The US government has a technology, called a printing press, that allows it to produce as many dollars as it wishes at essentially no cost.… Under a paper-money system, a determined government can always generate higher spending and, hence, positive inflation.”

Thus, it should be abundantly clear that before allowing the US to fall into another Great Depression and associated deflation the US  Federal Reserve will aggressively foster an inflationary environment that will allow the government to make its debt payments and reactivate aggregate demand. There can be little room for doubt that under such inflationary circumstances, nominal yields on US Treasury bonds would rise sharply.

Scenarios In Which Bond Yields Would Not Rise

There are essentially two scenarios under which long-term Treasury bond yields conceivably might not rise from current levels within the next two years. I consider these scenarios to be of extremely low probability.

Japan-style muddle-through. In Japan, long-term bond yields stayed extremely low for very long periods of time. Many hypothesise that same outcome for the US in the coming decade. However, there are extremely powerful reasons to surmise that such an experience will not be repeated in the US

First, savings rates in Japan were and are extremely high. This excess savings was the key factor that kept long-term interest rates low. Another key was the particular nature of the Japanese savings culture and corresponding nature of Japanese savings institutions such as the postal service. The US does not enjoy anywhere near this degree of “captive” financing. Indeed, the US depends on a highly fluid financial system and potentially unreliable foreign sources to finance its deficit.

Second, there is a virtually unanimous academic and policy consensus in the US that the Japanese central bank and central government were not nearly aggressive enough in combating the contraction of aggregate demand and the concomitant deflationary environment. The consensus of academic and policy opinion in the US is that if faced with a similar predicament, the US  Federal Reserve should be much more aggressive in stimulating inflation and aggregate spending. See Bernanke’s remarks above.

Rate caps. In his famous speech, Bernanke floated the idea of rate caps. This would involve the  Federal Reserve targeting interest rates on a whole range of government and non-government securities. This would work through unlimited authority for purchases of US Treasuries by the  Federal Reserve plus the provision of unlimited guaranteed long-term 0% liquidity to banks in order to purchase non-governmental debt securities.

It is important to note that it is not necessary that the  Federal Reserve necessarily keeps long-term interest rates at extremely low levels in nominal terms. The requirement is that the  Federal Reserve keep long-term nominal rates near or below the inflation rate anticipated by the market.

While a rate-cap scenario such as the one described above can certainly not be discarded out of hand, I believe that it is highly unlikely that the  Federal Reserve would adopt such a policy before long-term rates had already spiked to dangerous levels, thereby forcing the  Federal Reserve’s hand. Politically, such a drastic measure could only be justified in the event of an actual, and not an imagined spike in rates. The  Federal Reserve would attempt many alternatives to keep rates down at reasonable levels before resorting to such a drastic contingency.

Conclusion

When one carefully examines the universe of possible scenarios, one arrives at the conclusion that the overwhelmingly probable path for yields on long-term Treasury Bonds is up. In other words, the direction for US Treasury bond market prices is likely to be down. Yields can continue to spike downward in the short-term because of “safe-haven” buying. However, such low yields cannot be sustained beyond a year or two, at most. 

Market expectations of plausible longer-term scenarios, including  Federal Reserve interventions, will simply not permit rates to remain at such low levels for very long. All plausible long-term scenarios point to higher long-term Treasury yields. If the US economy recovers, yields will rise. If the US economy falls into recession and default risk rises, yields will spike. If the US economy falls into recession and the  Federal Reserve takes aggressive action, inflationary expectations will rise and nominal bond yields on long-term Treasury securities will spike.

Indeed, scenarios two and three could occur in succession. In other words, fear of default could drive an upward spike in rates. This would be followed by aggressive  Federal Reserve actions alluded to above which would assuage fears of default but which would increase long-term inflationary expectations thereby maintaining yields at relatively high levels (although perhaps not in real terms).

In sum, betting on a rise in long-term Treasury Bond yields over the course of the next year or two – e.g. the 10-year bond yield to a level of 4% at minimum – strikes me as one of the highest probability trades that I have encountered in my entire investment career.