Bill Gross is calling the bond bull market over. The Chinese said they find Treasuries "less attractive". However, I think the bond market selloff has gotten ahead of itself, and I'm a buyer. Here is how I'm positioning.
Technicals are bad, but are they that bad?
Gross is arguing that the 25-year bond bull market is over because we've crossed over some key technical levels. I agree that crossing over 2.50% does break a recent trendline, and so arguing for a continued selloff isn't crazy. But I think it is crazy to call a multi-decade bull market, one built on a variety of long-term structural factors, over just because we cross over some trend line.
Regardless, if you take a closer look at the technical picture, it actually doesn't look that bad. As I write, the 10-year is at 2.59%. There should be strong support at 2.62%, which was a top in December '16 and revisited in March '17. Prior to that, it was also the level we peaked at several times in the second half of 2014, without breaking it. In addition to that, the 10-year futures contract is oversold. With support very nearby and sitting on an oversold condition, I think it sets up better as a buying opportunity, than a short.
But if China starts selling, aren't all bets off?
I put almost no weight on this China story. China's buying and selling of Treasury bonds is entirely related to managing their currency. This conspicuous announcement likely has political motives in trade negotiations with President Donald Trump. However, it will only have teeth if in fact China wants to strengthen its currency.
Perhaps more importantly, Chinese net buying of Treasuries hasn't been obviously impactful on interest rates in recent years. From September 2012 to November 2013, China's holdings increased 14% or $160 billion. Treasury rates rose 90bps during that time. China was then a net seller of nearly $100 billion from November 2013 to February 2015. Treasury rates fell 80bps. From November 2015 to November 2016, China was a net seller to the tune of $215 billion, and the 10-year rose a whopping ... 10bps. That doesn't even really tell the story, because all of that rate rise happened in one month: November 2016. So, the fact that rates rose at all during that period had nothing to do with China and everything to do with Trump's election. Chinese selling Treasuries is a bogey man that you can safely ignore.
Fundamentals don't support Treasury rates this high
At the end of the day, long-term Treasury yields are overwhelmingly a function of two things: future inflation and future Fed policy. Focusing on the later first. Today's 10-year Treasury rate should be roughly equal to what the market thinks the average overnight rate will be every day for the next 10 years. If you think about it for a moment, you can see this has to be true. If you somehow knew for a fact that the Fed was never going to hike above, say, 2%, you'd always be a buyer of the 10-year at 2% or higher. With this in mind, I often do an exercise where I try to justify today's Treasury yield levels by simulating a forward path for the Fed.
If you run that exercise today, it is nearly impossible to get to 2.60% on the 10-year without some big changes in the current Fed outlook. Right now, the fed funds futures market is pricing that the Fed will stop hiking for this cycle around 2.125%, or three more rate hikes. If you assume that the Fed actually gets to five-six more rate hikes (depending on the pace) and stops there, you get to about 2.60% on the 10-year. The problem with that simplistic analysis is it assumes there is no change in the business cycle at any point in the next 10 years. That isn't realistic. What is much more likely is that the Fed keeps hiking but at some point has hiked too far and touches off a recession. During the recession, of course, they cut rates again.
Obviously, you could run limitless combinations of hikes, then cuts, then hikes again, and get all kinds of "fair value" estimations for the 10-year. But the simplest way to think about it is this: Since we know at some point in the next 10 years the Fed will be cutting again, that implies that today's 10-year Treasury should trade below whatever rate the Fed peaks at during this hiking cycle. In other words, the 10-year can't trade permanently above fed funds, unless the Fed is going to be forever hiking. For what it is worth, the most logical scenario I came up with to justify a 2.60% 10-year Treasury involved the Fed hiking to 3.625% between now and 2020, a recession hitting in 2022 and the Fed cutting to 0.625%; the recession ends after just a year and the Fed hikes every meeting until it gets to 4.125%. While anything can happen, that seems pretty extreme to me.
What about future inflation?
Yeah, I said above that long-term Treasury yields are a function of the Fed and future inflation. In theory, if inflation were seen as rising rapidly, longer-term bonds yields could rise without any increase in Fed expectations. Again, anything can happen, but the Fed isn't going to allow inflation to get out of control. If anything, this Fed is more hawkish than the prior regime. Any nascent inflation will get stamped out. But more importantly, the structural issues that have been holding down inflation are deep and long-term in nature. We aren't about to see 3% inflation.
Trades I like
- I've gone outright long by buying 10-year Ultra and Long Bond futures contracts this morning. You want to make any bullish Treasury bet based on long-term bonds. The same Fed math exercise is fairly easy to justify the two-year and five-year Treasury, but not the 10-year.
- The ETF equivalent is iShares 7-10 Year Treasury Bond ETF (IEF) for the 10-year or iShares 20+ Year Treasury Bond ETF (TLT) for long bonds. I'd probably use options to simulate the leverage you can get in futures. Implied volatility in Treasuries is still pretty low, so going long calls is probably a better plan than shorting puts.
- Speaking of volatility, I've been doing some long vol trades in my strategies for the last six months by underweighting mortgage bonds and overweighting corporate bonds. You could simulate this trade by being long iShares iBoxx $ Invmt Grade Corp Bd ETF (LQD) and short (MBB) , but to really make money in it you'd need a silly amount of leverage. Rather, I'd say that if you are long iShares MBS ETF (MBB) or some similar fund, I'd sell.
- I had been suggesting an outright short on the five-year Treasury. If you are naked short, I'd cover this. In my strategies, I remain short the five-year futures contract, but it is paired with the longs in the 10-30 year part of the curve. As I said above, I'm now net long for the trade.
- I'm itching to get long USD, because it just seems like the sentiment is way too bearish, and people are overweighting the Japan/eurozone recovery. However, I don't see a good set up right now. I think if the DXY gets to 91.5, there should be support there.
- If you got long banks (or Financial Select Sector SPDR ETF (XLF) ) based on an interest rate call, I'd sell. XLF shows an obvious uptick the last week corresponding with the jump in rates. If you have a call on earnings the next couple weeks that's fine, but if it is just about interest rates, take your winnings and go home.
Tom Graff is a regular contributor to Real Money Pro, our site for active traders. Click here to get more great columns like this from Tom Graff, Paul Price, Doug Kass and others.