Time to Sell Bonds

Every time a frightening headline jolts the financial markets, investors flock to the relative “safety” of US Treasury bonds. But just how safe is a “safe” Treasury bond?

The most insidious and dangerous part of the global debt story is hiding in plain sight. US Federal debt is now roughly 85% of American GDP, according to “official” figures. But after including the present value of future liabilities like Social Security and Medicare, US debt-to-GDP soars to nearly 500%.

This kind of debt could push even the world’s most powerful nation down the slippery slope to default. If China, Japan and other big foreign American creditors abandoned the Treasury market, bond prices would plunge and bond yields (which move inversely to price) would soar. Tellingly, bond prices have been dropping already, despite the Fed’s massive $900 billion quantitative easing ($600 billion of new money and $300 billion from maturing securities) initiative designed to keep bond prices high and yields low.

US Treasury debt was once regarded as the safest in the world, but that is changing faster than most realize. Earlier this month the yield on 30-year Treasury bonds climbed briefly above 30-year fixed-rate mortgage securities. This bizarre configuration still persists, which means that the market views John Q. Mortgage-Holder as a safer credit than Uncle Sam. This is not a bullish development.

The Fed’s announcement of its $600 billion quantitative easing (QE) program was a shot aimed squarely at China in retaliation for the Middle Kingdom’s refusal to let the yuan float. In effect, the Fed is “exporting inflation” to China. Here’s how: Low interest rates and a cheaper dollar encourage assets to flow into China, pushing up the prices of Chinese stocks, commodities and real estate. This causes China’s workers – the source of cheap labor responsible for the bulk of China’s growth – to demand higher wages, thereby reducing China’s competitive advantage. Chinese CPI has accelerated to 4.4% on an annual basis and is quickly becoming a big problem. China’s criticism of Helicopter Ben’s latest round of quantitative easing is directly related to the inflation the US is now exporting to China. Ben has given them a choice: increase the value of your currency or inflate.

Neither choice is very attractive.

The Chinese need exports to maintain a high growth rate, currently 9.6% per year. They also need rapid growth to dampen potential domestic unrest. The vast majority of Chinese are rural and poor. Until these folks are integrated into the economy, China will remain trapped between the need for growth and the threat of growth-killing inflation. Like a cornered animal, this makes China potentially dangerous – especially when the policies of one of its biggest customers are fueling this inflation.

The Chinese are already busy trying to counteract the inflationary effects of Ben Bernanke’s QE2. They’ve raised both interest rates and reserve requirements at banks – the latter numerous times. They’ve also tried to slow the influx of foreign money through capital controls and to slow inflation through price controls. The one thing they haven’t tried is selling their massive holdings of US Treasury debt.

At almost $900 billion, China is the biggest holder of US Treasury securities. Selling some of this hoard would send some return fire Ben Bernanke’s way. We can’t think of a better way for China to rid oneself of dodgy US debt then to sell it right back to the American Federal Reserve. Should China start selling, bond prices could drop fast.

Perhaps the best clue to the future of bond prices is the market itself. Bond prices began falling in August after Ben Bernanke’s infamous Jackson Hole, Wyoming announcement of the Fed’s QE program. Subsequent rallies have failed to take out old highs, establishing a new downtrend in the process. The proper way to trade a downtrend is to use corrective rallies as selling opportunities.

Short-selling US Treasury debt is difficult to do for individual investors. However, we can use the T-bond options traded on the CME to construct a trade with both limited risk and the potential for a nice return. Our 115-00 downside objective is not unreasonable, especially when you consider that this is precisely where T-bonds were trading back in April of 2010, just prior to the “flash crash” in stocks.

Longer-dated options in bonds can be a bit thin, so patience may be required.

Regards,

Steve Belmont

for The Daily Reckoning