财经观察 1677 --- On return-free risk and the bond bubble

On return-free risk and the bond bubble
Posted by Sam Jones on Jan 13 11:04.

Why buy Treasuries? They are, to borrow Jim Grant’s phrase — “return-free risk” — not exactly an attractive asset class.

Talk of a bond bubble to boot, abounds. Should we be anticipating the pricking of that bubble?

At its heart the argument comes down to a simple macro outlook: inflation or deflation.

Wracked by fears of deflation through 2008 - and a series of extraordinary policy measures from the government and the Fed — Treasuries outperformed the S&P 500 by a remarkable 53 percentage points (See the Economist). A rally all the more remarkable for its occurence concurrent with, as Brad Setser notes…

The outstanding stock of marketable Treasuries not held by the Fed [rising] from about $3795 billion to about $5480 billion.

With that, and the incredible expansionary policies now in place at the Fed, though, comes the fear that deflation will fall-away in the medium term and be replaced with a sharp inflationary spike. Something that would catch the bond market by surprise.

And so to the inflationary side of the fence. Pimco’s Mohamed El-Erian, recently warned:

Get out of Treasuries. They are very, very expensive .

Short and sweet. Barron’s cover article had plenty of reason’s too why Treasuries should be ditched. For example:

While a holder can expect to get repaid in full at maturity, the price of longer-term Treasuries could fall sharply in the interim if yields rise. The 30-year T-bond, for instance, would drop 25% in price if its yield rose to 4.35%, where it stood as recently as Nov. 13.

ALL of this boils down to one judgement: are the Fed’s measures working, and if so, how quickly are they working? If quantitative easing is working, then the market may rebound quickly, given the size of the policy action. In which case, the Treasury sell-off could be brutal.

There are too, plenty of other bond markets - almost as safe as US Treasuries - which could be considered relatively undervalued right now. GSE debt, for example. Or bonds issued by banks. Both carry a silent guarantee from the US government. But debt from both is far, far cheaper than Treasuries. A re-allocation of assets out of Treasuries now that the most acute phase of the financial (not economic) crisis is over seems a distinct possibility.

But.

Once again, comparison’s to Japan are germane.

Shorting JGB’s was a also popular pundit play in the 1990s. For very much the same reason as now, the bonds were said to be wildly overvalued. ZIRP could not last, it was said. It was a theoretical policy. Inflation would result.

Unfortunately, the ZIRP did last. And yields stayed low. The yield curve stayed flat.

Part of the reason: For Japanese banks, faced with bleeding balance sheets; ravaged by the worst effects of deflation, JGBs were a sound buy. The banks made happy returns from the carry and rolldown on the government bonds: knowing that they would all continue to buy huge amounts of them and keep prices depressed.

Indeed, it’s not quite fair to label, as Grant does, Treasuries return-free risk: If you can borrow at 0 per cent, and then buy 10 or 30 yr notes yielding around 2.32 and 3 per cent respectively, then the return - unlevered - really isn’t so bad based on the carry and roll alone.

And as Bred Setser has previously noted, US institutions are buying Treasuries. Did they do so purely in response to the September crisis? Or are they doing so with a longer timeframe in mind? More specifically: two years of deflationary pressures that will make carry and roll trades on Treasuries attractive.
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Here’s our take. There is a bubble in Treasuries. But it is an engineered bubble. One which has been encouraged and one which will only pop as rapidly as the economy recovers. Given that the weight of macroeconomic turbulence has yet to hit, that popping shouldn’t be total and shouldn’t come all at once or for that matter, anytime too soon. And while other areas of the bond market are looking attractive, they are so only because fears of the worse corporate default rate since WW2 are very real and very persistant.

The Fed might be wrong, but everything they have said so far points to a three year time-frame for current expansionist policies. Or longer. Here’s chairman of the Kansas Fed, Thomas Hoenig on Bloomberg last week:

Hoenig noted that if the Fed does not remove liquidity in 4-5 years, there will be serious problems ahead - we would say that if the “liquidity” is not withdrawn (to a large extent) in a much shorter period of time, then the possibility of a strong burst of inflationary pressures appears inevitable. One can also argue that the comments suggest the Fed is being rather economical with the truth about its outlook for the US economy, as sustaining the liquidity injection for such a period infers that the Fed sees the economy down on its knees for a similar period of time.

As Hoenig makes clear, the Fed too are aware of the inflationary dangers of QE. For now though, the money multiplier is still low. Which means that the expansion in monetary base, so far, has not been transmitted. Deflation is still very much on the horizon.

And the Fed very much has an interest in the price on Treasuries. The whole point of QE is to manipulate yields in a more direct fashion than regular monetary policy allows.

The wildcard in all this is China: its holdings of Treasuries are so large that its behaviour can influence the market almost as much as that of the Fed can. A chinese reorientation back into GSE debt, for example, would be a big setback for Treasuries, and one that could spark a selloff.