200 Years of U.S. Treasury Yields - Short the 30-Year, Ticker: TMV

The Fed increased the Federal Debt Ceiling dozens of times over the past year, and it seems like it is not over for the Bernank. The Fed's balance has been growing every single day as he pumps the economy with more liquidity. Here is a link to the NY Fed's POMO schedule: http://www.newyorkfed.org/markets/tot_operation_s….

In the SocGen chart above, you can see 200 years of U.S. treasury yields. From the chart, you can see why we are currently in danger of rising yields. We have a combination of oil shocks and riots facing the world today, with the threat of stagflation. Almost every emerging market has raised rates over the past 6 months: Singapore, Brazil, India, you name it. Even Europe, which is in a MUCH worse fiscal situation than the United States, is now "vigilant" on inflation and may raise rates in April...http://www.independent.ie/national-news/trichets-….

According to Bill Gross of PIMCO, "Treasury yields are perhaps 150 basis points or 1½% too low when viewed on a historical context and when compared with expected nominalGDP growth of 5%...This conclusion can be validated with numerous examples: (1) 10-year Treasury yields, while volatile, typically mimic nominal GDP growth and by that standard are 150 basis points too low, (2) real 5-year Treasury interest rates over a century's time have averaged 1½% and now rest at a negative 0.15%! (3) Fed funds policy rates for the past 40 years have averaged 75 basis points less than nominal GDP and now rest at 475 basis points under that historical waterline."

In the charts here on the LA blog, you can see (1) the % of investors who own U.S. Treasuries, (2) who is currently buying, and (3) who will buy? The third chart is in question. Someone will buy, but at what price and yield? What will this mean for the U.S. yearly interest burden, for U.S. tax hikes in the future?

One can conclude from these thoughts that yields will have to increase, especially if QE3 is announced in June, and unless the economy booms, so will tax rates. Here are Mr. Gross thoughts on QE:

"Most observers would agree with us at PIMCO that QE I and II programs were initiated and employed under the favorable conditions of (1) and (2). The third criterion (3), however, is more problematic. A successful handoff from public to private credit creation has yet to be accomplished, and it is that handoff that ultimately will determine the outlook for real growth and the potential reversal in our astronomical deficits and escalating debt levels. If on June 30, 2011 (the assumed termination date of QE II), the private sector cannot stand on its own two legs – issuing debt at low yields and narrow credit spreads, creating the jobs necessary to reduce unemployment and instilling global confidence in the sanctity and stability of the U.S. dollar – then the QEs will have been a colossal flop. If so, there will be no 15%+ tip for the American economy and its citizen waiters. An inflation-adjusted "negative buck" might be more likely.

Washington, Main Street – and importantly from an investment perspective – Wall Street await the outcome. Because QE has affected not only interest rates but stock prices and all risk spreads, the withdrawal of nearly $1.5 trillion in annualized check writing may have dramatic consequences in the reverse direction. To visualize the gaping hole that the Fed's void might have, PIMCO has produced a set of three pie charts that attempt to point out (1) who owns what percentage of the existing stock of Treasuries, (2) who has been buying the annual supply(which closely parallels the Federal deficit) and (3) who might step up to the plate if and when the Fed and its QE bat are retired. The sequential charts 1, 2 and 3 are illuminating, but not necessarily comforting.

What an unbiased observer must admit is that most of the publically issued $9 trillion of Treasury notes and bonds are now in the hands of foreign sovereigns and the Fed (60%) while private market investors such as bond funds, insurance companies and banks are in the (40%) minority. More striking, however, is the evidence in Chart 2 which points out that nearly 70% of the annualized issuance since the beginning of QE II has been purchased by the Fed, with the balance absorbed by those old standbys – the Chinese, Japanese and other reserve surplus sovereigns. Basically, the recent game plan is as simple as the Ohio State Buckeyes' "three yards and a cloud of dust" in the 1960s. When applied to the Treasury market it translates to this: The Treasury issues bonds and the Fed buys them. What could be simpler, and who's to worry? This Sammy Scheme as I've described it in recentOutlooks is as foolproof as Ponzi and Madoff until… until… well, until it isn't. Because like at the end of a typical chain letter, the legitimate corollary question is – Who will buy Treasuries when the Fed doesn't?"

So, how do we short Treasuries at Leverage Academy? Using TMV, Direxion Daily 30-Year Treasury Bear 3x Shares. Actually, this security should not be used for prolonged periods of time, but has tracked treasury yields fairly well on a daily and weekly basis. You can always maximize your return on your treasury short by using longer dated securities.

What can the House and Senate do to address the U.S. deficit? We can only hope that they will act to preserve our currency's status, otherwise global inflation will continue. According to Reuters, "the Republican-controlled House of Representatives will hold off on raising the government's debt limit until Washington is closer to exhausting its $14.3 trillion credit line, sometime after mid-April, party leader Eric Cantor said on Wednesday.

There is often a pitched battle in Congress over allowing the government to borrow more money, but if Congress does not take that step, Washington risks a default on its debt that could damage U.S. access to credit markets, force suspension of government payments, and close federal offices.

The U.S. Treasury Department estimates the debt ceiling could be reached between April 15 and May 31.

"We really don't know exactly when the date will be that we'll have to act," Cantor said on MSNBC's "Morning Joe."

"You know, we're waiting for April 15 and tax revenues to indicate exactly when the date is that the ceiling needs to be raised," he added. The must-pass debt limit increase may be leveraged to rein in future spending, Cantor noted.

Cantor spokeswoman Laena Fallon later said the majority leader was not suggesting the House would act on April 15, a date both symbolically important to tax-conscious Republicans and practically important to the U.S. Treasury as the deadline for income tax payments.

"April 15th isn't a date certain for consideration of the debt limit. But the revenues that come in from tax day will provide a good indicator in relation to when Treasury might determine when we will reach the debt limit," she said.

Some Republicans, including Tea Party conservatives, have said they will not vote to allow the United States to go deeper into debt without agreement on controlling spending with Obama and Democrats.

"Along with that vote, we're going to see a lot of things put in place, whether they be process reforms as far as the budget is concerned, spending caps, whether we can demonstrate that we are tightening the belt this fiscal year," Cantor said.

"Those are all the kinds of things we're going to have to do prior to seeing that that vote happens," he added.

The Republican-run House has passed a budget bill for the current fiscal year that includes $61 billion in spending cuts, but the majority Democrats in the Senate say the cuts would endanger the economic recovery.

A debt limit increase would also have to be approved by the Senate and signed by President Barack Obama.


Comments (4)

Mar 4, 2011 - 2:46pm
BananaStand, what's your opinion? Comment below:

I respectfully disagree. Input prices are high and the consumer is unemployed. Corporate margins will suffer and we will be left in a low/no inflation environment for longer than the market expects.

I know people may think low inflation for the near-term sounds crazy, but does anyone remember January 2010 when the market had priced in an increase in the Fed Funds rate in 2H 2010? That didn't happen. Instead we had QE2.

Read Richard Koo. He might not be 100% right, but his comparisons of the current U.S. situation and Japan 20-25 years ago are eerie.

Mar 4, 2011 - 3:19pm
GoodBread, what's your opinion? Comment below:
I respectfully disagree. Input prices are high and the consumer is unemployed. Corporate margins will suffer and we will be left in a low/no inflation environment for longer than the market expects.

That's how I have felt for a while but the economy is truly starting to pick up and the beginning of a trend in NFP numbers and unemployment is discernible. Unless the Middle East blows up and oil spikes to $150-$200 (very legitimate possibility), I think we'll see signs of inflation by the summer, espcially once Europe raises rates and we start reducing our trade deficit. The big move up and beyond the long-term trend isn't for tomorrow but it's coming.

Mar 4, 2011 - 7:42pm
jdog112, what's your opinion? Comment below:

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