Inigo Montoya: Who are you?
Man in Black: No one of consequence.
Inigo Montoya: I must know...
– Princess Bride
Again it must be asked: Who is buying long-dated Treasury bonds?
In other words, why are December T-bond futures trading at new recent highs? Why has TLT (the popular long bond ETF) decided to take graceful upward leave of its 50-, 100-, and 200-day exponential moving averages, with the 50-day EMA in particular showing notable upward slope?
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Over the past 24 hours, your humble editor has become temporarily obsessed with this question. It seems an important clue as to what is happening... and unexpected breakouts are far more interesting than highly anticipated ones. As the legendary hedge fund manager Bruce Kovner observed in Market Wizards,
The Heisenberg principle in physics provides an analogy for the markets. If something is closely observed, the odds are it is going to be altered in the process. If corn is in a tight consolidation and then breaks out the day The Wall Street Journal carries a story about a potential shortage of corn, the odds of the price move being sustained are much smaller. If everybody believes there is no reason for corn to break out, and it suddenly does, the chances that there is an important underlying cause are much greater.
In addition to Kovner’s insight, there is another reason why unexpected breakouts are worth noting. By virtue of their very unexpectedness, they tend to catch folks by surprise. The forced adjustment process becomes fuel for the ensuing move.
Earlier this week, we briefly recapped the bearish long bond case. And it’s a doozy of a case. The following data table from Sprott Asset Management does a nice job of driving the point home with a sledgehammer:
Total outstanding U.S. debt, 11.8 trillion dollars. Unfunded Social Security obligations, 17.5 trillion dollars. Unfunded Medicare obligations, 89.3 trillion dollars. Printing the world’s reserve currency – priceless.
A few back-of-the-envelope calculations tell us that lending to Uncle Sam at this point makes about as much sense as giving another mortgage to the house flipper in Vegas who is already juggling 19 properties on a $30K income. And yet, once again, 30-year USTs are going up, not down... hence the mystery.
We also speculated that deflation – or rather, future expectations for deflation – have something to do with the breakout. Again, though, this seems pretty goofy when one considers the time frame in question. Given the history of fiat currencies, does one really want to lend at 4% interest rates (give or take) for thirty years? Really?
The experience of other countries also belies the “deflationary expectations” thesis. Across the pond, for example, investors are expecting a serious bout of inflation down the road. As the Financial Times reported last week, “Investors overwhelmed the UK with demand for inflation-linked bonds yesterday... many fund managers are worried about prices surging out of control in the next few years.” Hmmm.
The mystery remains. Here are a few theories as to who might be buying.
Boomers and Coffee Cans
In a recent Barron’s interview, noted analyst David Rosenberg observed that hard-up baby boomers could be the ones reallocating their capital into bonds.
When you look at the household balance sheet – and this is the largest balance sheet in the world – 25% of it is in equities. Even today, 30% is in real estate, 12% is in cash, and less then 7% is in fixed income. The remainder is mostly in life-insurance policies and pension funds. But fixed income is the part of the asset pie that will expand the most over the next five to 10 years.
When you look at the labor market, the 55-and-up age group is the only one that has posted any job growth in the past year. They aren't coming back into the workforce because they want to. They are doing it because they have to. They need the income to make up for the record amount of lost net worth that they endured. From a life-expectancy table, they can see if they made it to 52, they are probably going to make it to 82. They aren't going to make up for all that lost wealth, but there is this growing realization that the boomers are going to have to prepare for retirement the old-fashioned way – by putting more of their income into the coffee can, as opposed to buying more coffee cans.
This would naturally explain why corporate and municipal bond funds are booming. There are a number of relatively safe options out there, in contrast to the unattractive prospect of lending long to Uncle Sam. But still, why 30 years?
Perhaps nervous boomers have become fixated upon the word “safe,” to the point where lending to the government seems a good deal to them. With such a small portion of household savings (less than 7%) devoted to fixed income, there have to be at least a few frightened investors who want to avoid the next General Motors (or General Electric for that matter) at all costs, which would mean buying USTs. The risk of getting mauled by inflation may feel less immediate in comparison.
An Old-Fashioned Short Squeeze?
Another possibility relates to the overcrowded nature of the short bond trade.
The Proshares UltraShort 20+ Year Treasury ETF (TBT:NYSE) has proven immensely popular, with average daily volume above 5 million shares. TBT is designed to rise when long bond prices fall. Thus, to go long TBT is to cast a predictive vote for rising interest rates, rising inflation expectations, and deteriorating credit conditions fueling a loss of faith in Uncle Sam.
The thing is, the logic behind this trade may have become too obvious. When that happens, the odds of a nasty correction increase significantly.
Markets are perplexing to the uninitiated in that, unlike high school, it is possible for an idea to be too popular. The conventional wisdom often gets pushed too far. If everyone and their brother becomes convinced that TBT is a buy (and, conversely, that long bonds are an obvious sell), that leaves no one left to take the other side of the trade... and so the trade reverses, to the consternation of many.
The Resurrection of Bretton Woods 2.0
The final possibility goes back to something known as “Bretton Woods 2.0.”
To quickly recap, the original Bretton Woods was a post-WWII agreement (ratified July 1944) that established fixed exchange rates for global currencies versus the U.S. dollar and gold. Decades later, Bretton Woods was abandoned in stages and ultimately killed by President Nixon.
“Bretton Woods 2.0” was the tongue-in-cheek nickname for the unofficial arrangement by which Asian exporters and Middle East oil interests financed the borrow-and-spend habits of the United States. In sum,
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The American consumer spent huge sums, courtesy of inflated home prices and easy credit.
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Dollars flowed to the Middle East and Asia to buy oil and “stuff.”
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Asian exporters and Middle East oil interests recycled their excess dollars back into U.S. Treasuries.
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Artificially low interest rates (sustained by Asia/Middle East UST purchases) fueled low mortgage rates and easy access to consumer credit, perpetuating the cycle for an astonishing length of time.
If you’ll remember, there was a raging debate over how long “Bretton Woods 2.0” could last. (It was in the midst of this debate that Fed Chairman Bernanke introduced the term “global savings glut,” as if to say it was the rest of the world’s fault for not having anything better to do with their savings than pump them back into an overheated U.S. economy.)
As we now know by virtue of hindsight, Bretton Woods 2.0 finally blew up when the U.S. consumer blew up... and the U.S. consumer blew up because the housing bubble blew up. Leverage and debt had gotten so out of hand, it was pretty much guaranteed to happen at some point.
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Now that long bonds are rising (and interest rates falling) yet again in the midst of speculative frenzy, your editor idly wonders... could a similar dynamic be at stake? Could this be a new, bastardized version of Bretton Woods 2.0, in which Uncle Sam is the big spender rather than Joe and Jane Homeowner?
If so, the dynamic might look something like this:
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The U.S. government (Fed and Treasury) pumps trillions of dollars’ worth of “funny money” into the market through all manner of bailouts, asset guarantees, alphabet soup programs and whatnot.
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Hundreds of billions’ (trillions?) worth of this “funny money” gets funneled into fresh speculative activity... winding up with, say, aggressive equity purchases in Brazil.
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The dollars that flow into Brazil (just for the sake of example here) to buy Brazilian equities eventually make their way to the Brazilian central bank... which, in turn, recycles those dollars back into U.S. Treasury bonds (for lack of a more compelling option).
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Low long-term interest rates (and near zero short-term interest rates) perpetuate the ongoing gaming of the system as the Fed and Treasury get ever more aggressive in their “funny money” operations, with global central banks complicit in this Ponzi scheme via fresh UST buying, and voila... a Frankenstein version of Bretton Woods 2.0 (Bretton Woods 3.0?), with the U.S. government at its heart, is born.
If this last bit of theoretical noodling is anywhere close to the mark, then we could in big, big trouble... sowing the seeds of a future crisis that makes 2008 look like a mere preseason warm-up.
And how about you, dear reader? Any insights or theories as to why long bonds are heading higher, or what the trading and investing implications might be? Inquiring minds want to know: justice@taipandaily.com
Warm Regards,
JL
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