Kass: Sell Bonds Short

This blog post originally appeared on RealMoney Silver on Jan. 16 at 7:32 a.m. EST.

The bond market is in a bubble that is reminiscent of (and quite possibly as extreme as) other bubbles during previous eras.

From my perch, the only issue is the timing of this trade.

Surprisingly, today's 3.68% yield on the 10-year U.S. note is lower than the yield during the recession of 2001. This low yield appears to be artificially affected by a number of temporary and backward-looking factors.

Here are the principal reasons why I would short bonds now -- and with impunity.

• The economic stimulation is (or will be) coming from several directions:

  1. The Fed has likely embarked on a lengthy period of aggressive easing.
  2. The administration is planning a broad fiscal stimulation package, and the Democratic contenders are proposing fiscal relief and pro-growth messages.
  3. The recent drop in the price of oil will likely be followed by a general decline in other commodities.

  These trends can be viewed as an effective tax decrease.
• There are fewer credit shoes to drop. The housing/subslime problems that have moved up the credit ladder now seem to be recognized by most. While counterparty risks with regard to credit default swaps should not be ignored, it is likely that few new problems will arise that are as consequential as those that mired the markets over the last 12 months. Consequently, the flight-to-quality trade might be about over now. As well, improving TED spreads and a lower Libor are moving in a direction that suggests the credit woes are lessening.
• Suppose my economic fears are exaggerated and don't come to pass. A deep recession is now likely priced into bonds. If my friend/buddy/pal Brian Wesbury is correct and the economy doesn't fall into recession, bonds will get destroyed. Even a relatively shallow recession could now produce a rise in interest rates against current levels.
• Inflation is still an issue. Despite the Bureau of Labor Statistics' readings, inflation remains elevated and is not reflected in the current level of interest rates. The expected fiscal and monetary stimulation in the upcoming months will only serve to exacerbate inflationary pressures.
• Central banks are diversifying away from U.S. government bonds. With the creation and proliferation of sovereign wealth funds, a growing portion of central bank reserves are being invested in non-bond assets. So, over time, central banks (especially of an Asian kind) could be lowering their U.S. bond purchases.
• Momentum investors are exaggerating the bond price move. As with the situation in other commodities (gold, silver, energy products, etc.) from 2004 to 2007, I believe momentum traders are piling into the bond trade simply because it is working. This will not be a permanent issue. Momentum investors, as we have recently witnessed, are notoriously fickle and have quick trigger fingers.