The Case for Shorting U.S. Bonds

The column originally appeared on Real Money Pro at noon Monday.

NEW YORK (Real Money) -- Bonds have achieved a near 50% total return since year-end 2009. With those outsized returns, shorting bonds has been a toxic strategy.

Over the last half century, bonds have historically been considered a risk-free asset class.

Nevertheless, I believe bonds should now be seen as a return-free asset class that is very risky, and long-dated fixed income should require a warning label for all potential buyers.

Historical Returns

The great bull market in bonds has persisted during most of the last four decades.

Over the last 38 years (since 1974), the total return on the long bond registered negative returns in excess of 5% in only four years: 1987 (-6.3%), 1994 (-12.0%), 1999 (-14.8%) and 2009 (-25.5%).

Below is the table of the annual returns on bonds since 1974 (Source: Ron Griess, TheChartStore.com):

The market landscape is littered with investors and traders who have unsuccessfully shorted U.S. bonds over the last two years.

It has been a painful experience, but often the hardest trades (and those that have been most unsuccessful) are the most profitable going forward.

So, before I outline the rationale behind the five key reasons to short bonds, given that the burden of proof lies squarely on the shoulders of the bond naysayers, I wanted to start with the five reasons not to short bonds.

Five Reasons Not to Short Bonds

Above all, the U.S. economy faces powerful secular headwinds that weigh as an albatross around the neck of a trajectory of self-sustaining growth.

1. The forecast? Muddle-through growth:At best, muddle through remains the baseline expectation for domestic economic growth for 2012.
2. A feel-bad environment: Deleveraging and caution associated with the pronounced economic downturn of 2008-2009, coupled with structural unemployment, represent a confidence deflator and act as a governor to personal consumption over the near term.
3. The Bernanke put: The Fed will likely anchor short-term interest rates as far as the eye can see. More quantitative easing will be on deck if the domestic economic recovery falters.
4. A large manufacturing output gap: Capacity utilization rates are nowhere near levels that are typically associated with demand-pull inflation.
5. A negative demographic shift: Aging baby boomers are ignoring stocks, preferring to buy risk-free fixed income products. After two massive drops in the U.S. stock market since 2000 and a lost decade for equity investors, this rapidly growing demographic seems to continue to have an almost insatiable appetite for bonds.

In summary, the positive case for U.S. government (and corporate) debt is that there are numerous cyclical and secular factors that will weigh on domestic growth serving as a significant hurdle against the short bond thesis.

Five Reasons to Short Bonds

It is my contention that even if domestic economic growth is constrained, a bond short can prosper, even under the baseline expectation of a muddle-through growth backdrop.

1. The flight to safety will likely have a diminishing half-life. With some progress being made in Europe (reflected in lower sovereign debt yields and sharp rises in European stock markets) and with confidence in the world's financial system improving, it is only a matter of time before the flight-to-safety premium in bonds dissipates.

Bond yields are unusually low, and I would note that the current 10-year U.S. note (2.0%) is approximately one-half the yield of the recession of the early 2000s. Gold prices already suggest that the safety premium could disappear sooner than later. (I view gold as a fear trade, and the recent drop in gold prices should be seen as a forward indicator of less fear.)

While U.S. economic growth remains subpar, a reacceleration is inevitable in the fullness of time. Demand for durables (housing and auto) is pent-up, not spent-up, and continued population and household formation growth will serve to unleash latent demand at some point in time.

In an attempt to put the flight-to-safety premium in bond prices into perspective, the chart below (courtesy of BTIG Chief Global Strategist Dan Greenhaus) compares the yield on 10-year and 30-year notes and bonds to nominal U.S. GDP (nominal GDP = current real GDP + current inflation). Over the last five decades, long-dated bond yields have tracked (and averaged only slightly under) the nominal growth rate in the U.S. -- 4.4% (2% real GDP estimate + 2.4% current inflation) compared to the yield on the 10-year U.S. note of 2.0% and the 30-year U.S. note of 3.1% -- in fact, long-dated yields often exceed nominal GDP.

(Note: 10-year yield is black; 30-year yield is green; nominal GDP (year-over-year) is red.)

2. Flows out of stock funds and into bond funds seem to be at a tipping point. Since 2007, nearly $450 billion has been redeemed from U.S. equity funds, and $850 billion has been placed into U.S bond funds. This swing, of $1.3 trillion, is unprecedented in history. In early 2012, the hemorrhaging of stock funds has stopped. It is my contention that, at some point, a massive reallocation from fixed income into equities is inevitable.

3. Confidence is recovering as economic growth reemerges and risk markets improve. As seen in the chart below, the real yield on the 10-year U.S. note correlates well with consumer confidence, which is now recovering.

4. Inflation remains an issue. A steady increase in inflation and inflationary expectations has occurred as most inflationary gauges (TIPS, etc.) are at six-month highs. I would not entirely eliminate the concern on demand-pull inflation as emerging markets grow more industrialized. Moreover, cost-push inflation is a growing possibility -- particularly in light of geopolitical pressures that could create a black swan in the price of crude oil.

5. The failure to address our fiscal imbalances could come back and bite the bond market. As I suggested in Friday's opening missive, the November elections might result in more gridlock. A Democratic president, and a Republican House and Senate imply that little positive progress should be expected in meaningfully resolving our burgeoning deficit in a still-divided Washington, D.C. This could encourage the bond vigilantes and further alienate foreign central bankers in their appetite for our bonds and notes. (Many are already diversifying away from the U.S. bond market.)

Strategy in Shorting Bonds

I readily admit that, in all likelihood, with U.S. GDP growth of less than 2% in first quarter 2012, bond prices will be relatively range-bound in the weeks ahead.

But any evidence of a resumption of growth will have a dual impact: It will likely reduce the flight to safety (reflected in bond premiums) and, at the same time, produce the historically normal and natural upward pressure on interest rates associated with an improving economy.

When this happens, bonds will, once again, become certificates of confiscation.

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