The Case for Shorting U.S. Bonds
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The column originally appeared on Real Money Pro at noon Monday.
Historical ReturnsThe 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):
Five Reasons Not to Short BondsAbove all, the U.S. economy faces powerful secular headwinds that weigh as an albatross around the neck of a trajectory of self-sustaining growth.
- The forecast? Muddle-through growth:At best, muddle through remains the baseline expectation for domestic economic growth for 2012.
- 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.
- 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.
- A large manufacturing output gap: Capacity utilization rates are nowhere near levels that are typically associated with demand-pull inflation.
- 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.
Five Reasons to Short BondsIt 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.
Strategy in Shorting BondsI 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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