The Case for Treasuries

2006-07-26

Today's Thought of the Day is a joint venture from Bennet Sedacca and John Succo at Minyanville.

From Bennet Sedacca:

I have received many inquiries about treasuries. Let's discuss why I am looking heavy into 2's, not 10's, and avoiding corporates altogether and now mortgages as well.

Obviously, a two year Treasury has less duration than a two note and has less volatility for a given change in rates. My firm is negative on the economy and expect the Fed to ease. So why not 10's? Because of the current shape of the curve. We already own some 2's from 5.25% and took some profits in 10's as mentioned here previously.

Let's say 2's go to 3.5%. I think the curve will be in a 'curve steepener.' In other words, rates on 2's will fall faster than the rest of the curve, taking the curve from flat to a more normal, steeper curve, prior to the end of the Fed's ending their easing campaign. So we buy TWICE AS MANY 2's as we would 10's and think we can actually make more money with the same or less amount of risk. In addition, we always like to ask ourselves, "what if we are wrong and rates rise?" Obviously, 2's will crush 10's in performance and we have our 2's to sell to extend into more duration.

Why only Treasuries? Well. Put it this way. I have been in the business 26 years or so. I have never seen, relative to an economic backdrop like we have now, so little value in corporates, agencies, mortgages, etc. I think spreads will eventually widen, perhaps DRAMATICALLY, which is normal in slowdowns.

Email Bennet at Atlantic Advisors.

From John Succo:

After reading the comment in Professor Bennet Sedacca's article, "I have never seen, relative to an economic backdrop like we have now, so little value in corporates, agencies, mortgages, etc." prompted me to write this.

What Bennet means by value is that investors are buying risky assets like corporate bonds at only a slight discount to non-risky asset like treasuries. They are willing to incur the risk of default, which should be higher for a company than for the U.S. government, for only a very small increment in yield. Bennet is describing an investor who is willing to take on too much risk for too little yield.

This is a phenomenon directly born of government policy, central bank intervention.

All central banks around the world have purposely driven real interest rates to zero or even below. Money is free. This means the worst of the worst, those willing to speculate and go bankrupt if necessary are free to buy risky assets. This forces risk premiums lower and lower. Even relatively conservative investors feel the pinch, the pressure to go out on the risk curve to just make a little money.

And the central banks want this. They have actually targeted lower volatility to encourage investors to take risk that they don't really see. Not until volatility rises does risk become apparent. So they are doing everything they can to keep volatility low and investors taking risk.

What happens if investors decide to take less risk? Heavens forbid they actually want to save money and not take on more debt. That would reduce risk and reduce liquidity. Volatility would go up and it would feed on itself. The credit bubble that has driven nominal asset prices to these levels (risky assets) would begin to unwind and the opposite would occur.

It is all about liquidity. Risk premiums are the largest variable in driving liquidity. People will be very surprised at how fast people want to reduce risk when they decide to. A very gradual and incremental process that has reduced risk premiums over the last several years can reverse quickly.

Central banks are doing everything they can to avoid this. Credit is being offered (money supply is high); will the market continue to keep taking it? My firm's work is showing the market on the margin is taking that credit less and less and it is going to the more and more speculative.

Hedge funds, mutual funds, and even pensions are taking the risk for the investor more than ever. These are in general managers that are once removed from the consequences of risk so they take more than the actual owner of the money would.

Bennet is saying that it [the risk vs. reward of corporates, of agencies, of junk bonds, etc as compared to treasuries] is not there, not by a long shot. I agree.

From Mish:

I was asked just yesterday by someone on Silicon Investor what duration I recommended. My reply was that the "sweet spot" was probably between two and three years. I went on to say that IF my deflation scenario pans out that the place to be might be 10 year notes or even the 30 year long bond. Obviously this depends on the amount of risk that one wants to take and I pointed that out as well.

Bennet raises an interesting twist that perhaps double weighting 2's might be a better strategy. Certainly that strategy has a better out. One can ride out a 2 year note far easier than the 30 year long bond if proven wrong, or one can convert (at a relatively small loss) to 10's or 30's for tremendous extra potential down the road.

I also need to comment on professor's Succo's observation. Risk premiums in general have been driven to zero. Risk has been not only encouraged but embraced. The case for treasuries goes far beyond just treasuries vs. agencies or junk. The case for treasuries extends across a multitude of asset classes. We are seeing emerging market ETFs, gold and silver ETFs, oil ETFs, etc etc, most of which opened up only after tremendous five year runs.

I remember the day JDSU leaps (long term options) were offered. I remember commenting "that marks the top in JDSU". I think I was close. For those of you not familiar with the JDSU fiber story, it fell from 100 to 2 and sits near that level still today.

Flash forward to today. Virtually no one likes treasuries. They are universally despised. This is somewhat odd given that treasuries are sill in a bull market (long term) and if we are about to head into K-Winter (as I think we are) treasuries may outperform every other asset class. Those unfamiliar or needing a review on the K-Cycle may wish to read The Kondratieff Cycle Revisited.

At no time in history have investors turned bearish at a market peak. I suspect it will never happen either. Yet that is what treasury bears want you to believe.

Yes, I know all of the arguments. Treasuries are manipulated, it's the "Caribbean Connection", if it was not for Japan or China treasuries would tank, etc etc. Yet many of those same people are willing to plow into stocks, junk bonds, real estate or whatever. It makes no sense. If treasuries collapse, the last place you will want to be is in junk bonds, housing, or US equities.

Yes there is an alternative, but it is not without risk. That alternative is of course gold and/or energy stocks. If I could pick two other sectors that were universally despised it would be gold and energies. The risk is what happens in global recession. That can't happen? Then again, I believe gold will do well in deflation (once all of the inflationists panic out).

Barron's recently came out with a cover touting big caps like CSCO and Home Depot. I talked about it in Think Outside the Box Score. If and when Barron's comes out touting treasuries, gold, or energies, it will be time to take the profit and run.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/