This commentary originally appeared on Real Money Pro at 11:36 a.m. ET on Friday, July 1. Click here to learn about this dynamic market information service for active traders.
On June 17, I wrote that returns in U.S. bonds were skewed to the positive. Despite interest rates falling to record lows since then, I stand by the view that bond returns are likely to be higher than their stated yield over the next year. If you want to hear the basics of my bullish argument, read the column I linked to above. Today, I'll counter Kass' main arguments for shorting bonds here, thus giving readers easy access to both sides of the matter.
1. Bond yields should be roughly equal to nominal GDP growth over the long run.
This argument is sound both theoretically and empirically. It should be true that Treasury bond yields reflect the opportunity cost of capital -- that is to say, Treasury bonds reflect the base return investors will accept when they can't find anything else to buy. If the economy is booming (i.e., GDP growth is high), there will be a lot of high-return investment opportunities. Treasury yields will have to rise in order to entice any capital. But if the economy is growing slowly and there isn't much to invest in, Treasury yields will fall since investors don't have much else to buy. Nominal GDP is the general growth rate of the economy, so it should be a rough gauge of the average return on investment across the entire economy. Hence, base yields should look sort of like GDP over time.
The problem with this argument is that the relationship only holds over the very long-term. The 10-year Treasury yield was below nominal GDP for basically the entire decade of the 1970s. Then it was above GDP from 1980 to 1995. Lately it has been running below GDP consistently since 2010. So while I will stipulate that there should be a relationship there, I don't believe that it is a good basis for a short thesis. The horizon is just way too long.
Perhaps more important, it isn't clear what GDP we should use when thinking about this relationship. Given that the U.S. is a world market, should we use world GDP? Should we use developed market GDP only?
2. Although U.S. yields are higher than other markets, that doesn't make them "attractive" outright.
Doug Kass uses the analogy that New York Yankee Alex Rodriguez isn't a "good" hitter just because he is batting 30 points higher in average than teammate Mark Teixeira. The relevant numbers are that A-Rod is batting a paltry .220 and Teixeira .190. "In reality, both stink," wrote Kass.
I take the position that the Yankees lineup, as well as a 10-year investment only earning 1.45%, both stink. Everyone wants or expects better results in both cases. But if one is considering shorting bonds, one must first understand the demand dynamics. Most bond investors (especially in Treasuries) own them primarily for something other than return. That includes capital treatment (banks, insurance), a need for U.S. dollars (foreign central banks), or legal requirements (Treasury money markets, Federal Pension). Of the $15 trillion in Treasury securities outstanding, $11.8 trillion are held by these sorts of buyers. Some of these buyers have flexibility to move out of Treasury bonds, but almost all of these have to hold bonds of some kind.
Regardless of what happens, they can't escape low interest rates. At that point, it becomes a matter of buying whatever type of bond has the best relative value. As it is, the U.S. bond market is by far the highest yielding among high-quality, high-liquidity markets. From this I conclude that until European and/or Japanese interest rates start rising, U.S. rates will struggle to rise materially. Should U.S. rates rise all on their own, it would only attract more capital from overseas. That doesn't mean that rates couldn't rise by some degree, but if you want to make a case for a big rate rise, you must make a case that rates in Europe and Japan will rise as well. In order to make that case, you have to believe that the ultra-accommodative policies in Europe and Japan would start to be reversed. Anything is possible, but that possibility seems remote to me.
3. TBT is a poor vehicle to express a long-run view.
One problem with shorting bonds is that you are paying out yield every day you hold the short, so the short needs to work out relatively quickly or it will become too costly. The ProShares UltraShort 20+ Year Treasury ETF (TBT) - Get Report vehicle specifically is an unattractive way to short bonds unless you have a very short-term horizon. This has to do with the math of how volatility affects a leveraged exchange-traded fund, which I won't get into here. But suffice it to say, that it creates additional leakage to the ultimate return an investor realizes.
Ultimately Kass' thesis is a long-term one, essentially saying that in the long run, investors will demand more yield than they are now. I'm sure that is true, but I have no idea how long the "long run" might be. Yes, 10-year securities at just 1.45% have a crappy valuation, but they lack a catalyst to change anytime soon. Indeed, the balance of risks is toward U.S. growth slowing, which would create more downward pressure on rates. Rates could certainly rise, but a material rise in yields -- enough to make a short attractive -- is much less likely than other scenarios.
Tom Graff is a regular contributor to Real Money Pro, a dynamic website for active traders and investors. For a free trial,