Saturday, August 14, 2010

Thinking about Treasuries

The 10 year yield has collapsed in a nearly unprecedented fashion to just under 2.70% from 4.0% on April 5. This about 1/3 drop in yields in just over 4 months with relatively little news is astounding and brings the yield to roughly the Fed's long-term inflation goal. The 200 day simple moving average is 3.46%. Even if David Rosenberg's target of a 1.5% yield is on target, then it would take a Fannie/Freddie/Lehman/AIG catastrophe to push yields much lower in the short term.

The long bond, exemplified by the on-the-run 30 year bond yield, is listed as yielding 3.87%, down from an April 5 high of 4.84%. My recollection of a 200 year chart of U. S. Government long bond yields from the year 2000 is that the long-term average was about 4.70%. Thus while the current yield is below average, it was about average only 4 months ago. There is no bubble in the long bond, and it is much less extended on the charts.

Supporting the idea that the prospective action for both traders and new money investors is in the long bond is that the spread between the 10 and 30 year is 118 basis points, a record since the long bond was instituted in 1979 except for a slightly greater spread intra-week. Dr. Rosenberg states that the average spread has been 50 bps. Looking at Japan, the spread is about 75 bps.

If the 10 year stabilizes at 2.75, which is midway between the zone of congestion the chart shows January-April last year as yields recovered from the post-Lehman panic, and if the 30 year moves toward a 75 bps spread, then the target for the 30 year is 3.5%, which is about where its zone of congestion from the same time period is. The upper part of the 30 year's congestion zone was 3.7% or so.

Thus various reversion to the mean based on chart/trading considerations, and absolute spread differentials between the 10 and 30 year bond, suggest to me that barring cataclysmic events, a very plausible scenario involves a zero to negative short term total return from the 10 year bond while the 30 year bond provides both slightly greater income and some capital gain potential.

The fundamentals of price inflation since the Fed was formed in 1913 are as follows. If it now takes a dollar to buy what a nickel bought in 1913, then the compound rate of price increases is 3.14% yearly. If the proper ratio is 3 cents to one dollar, then the rate of price increases rises to 3.68%. Meanwhile, gold has risen 4.3% yearly.

Thus numerous numbers hold together. In a chancy economic time and one of significant turbulence in the financial markets (as opposed to the real economy), the long Treasury bond and gold both appear to be fundamentally reasonably priced, and both have chart patterns that prove that they have been attracting buying support.

To those who argue for one of the above and not the other as trading/investment vehicles, please answer what is so different now as to change either trend? And please don't talk about the Federal deficit to argue against Treasuries; Japan disproves that argument.

My view is that long-term trends deserve great respect. When the 40 year old trend of rising interest rates ended in or around 1981, the actions by the Fed were obvious and followed crisis after crisis. What drastic policy change has occurred to change any of the major trends currently in force?

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