Conclusion: We covered our mean reversion short position in long term treasuries via the etf TLT yesterday as there are number of catalysts that will keep long term yields from increasing meaningfully through the end of June. Beyond that time frame, much of fixed income looks like it could be short (at a time and price).
Earlier today, we covered our short position in the etf TLT, which represents long term treasuries with a 20+ year duration. A key insight for us to enter this position was 10-year treasuries yields hitting basically an all-time low earlier last week at 1.70%. The chart below shows the long term range of the 10-year over the past decade. Currently, the yield of the ten year is 1.79%. This is more than two standard deviations below average yield of the last ten years of 3.8%.
Over the longer duration, the risk reward set up remains asymmetric for yields to increase. We can see this in our price ranges as the TRADE range is tight at 1.66% - 1.81%. Meanwhile, the TREND resistance level is 2.03%. So, up to our intermediate term support levels there remains significant upside in yields and downside in bond prices.
In the intermediate term, despite the massive longer term reversion to the mean potential, it is unlikely to be a money making opportunity being short U.S. treasuries for two key reasons:
- Operation Twist – The Federal Reserve’s operation twist is scheduled to continue through June 30th. By some estimates, the Federal Reserve has already surpassed their target of extending average maturities by 100 months, but regardless they will keep buying longer dated treasuries for the next forty days and this will keep yield increases muted.
- Europe – As highlighted in the chart below that compares 10-year yields of Germany versus Italy and Spain, the European debt debacle is far from resolved and will continue to support the relative safety (albeit very relative) of U.S. government debt. As our colleague Josh Steiner highlighted in a note yesterday on Greek elections, the looming June 17th election in Greece will have critical impact on the future of austerity and reform in Europe, and as a derivative the yields of European sovereign debt. If there is risk in European sovereign debt, U.S. treasuries will remain a safe haven of sorts.
Longer term, the increasingly key consideration will be the U.S. fiscal and balance sheet situations, which continues to deteriorate in the year-to-date. For starters, the Congressional Budget Office raised their estimate for the deficit in fiscal 2012 by $93 billion to $1.2 trillion in March. This key reason for this is because revenue has basically been flat year-over-year. As a result federal debt-to-GDP is hovering just over the 100% mark.
The key negative fiscal catalyst for Treasuries beyond June 30thand the end of Operation Twist is the debt ceiling getting hit again and the potential for another downgrade of U.S. sovereign debt (The caveat is that the last downgrade did not lead to an increase in yields.) The current debt ceiling is $16.4 trillion and the public debt balance as of May 18this $15.7 trillion. Interestingly, roughly seven months ago the public debt balance was $15.0 trillion, which at a similar rate of growth suggest we should hit the debt ceiling by the end of calendar 2012. Once again, this will be major political football that will increase consternation related to low historical yields.
One last point we wanted to highlight in this note was that of relative yields. In the table and chart below, we compare U.S. investment grade yields to U.S. junk bond yields to the earnings yield of the Dow Jones Industrial Index to the yields of 10-year treasuries. Not surprisingly, given the bubble in treasuries, there is a relative bubble of sorts in the rest of fixed income.
Specifically, both investment grade bonds and junk bonds are trading well below their long run average yields and at, relatively, tight spreads to treasuries despite the artificially low yields in the treasury market. Trailing twelve month earnings yields for the Dow Jones Industrial Index appear relatively cheap, but, as always, equity valuations depend on the future view of growth. Interestingly, historically the earnings yield spread between the DJII and 10-year treasuries has actually been meaningfully tighter than between junk bonds and 10-year treasuries. This implies high yield could be most at risk in a mean reversion scenario or if economic growth slows more dramatically.
Clearly, Japanese sovereign debt yields have stayed low despite major growth and fiscal headwinds. The same scenario may well play out in the U.S., or, as they say, this time could be different and reversion to the mean in the fixed income market could catch many off guard. As Hemmingway famously wrote:
“It occurs very slowly, then all at once.”
Daryl G. Jones
Director of Research