Email of the day
Comment of the Day

August 26 2010

Commentary by David Fuller

Email of the day

On US Treasuries and Bernanke
"I will not comment on the opinions of various economists regarding what another round of Quantitative Easing will do. I certainly respect John Hussman. I will say that I have remained bullish on 30 Year Treasury Strips and will continue to buy off of corrections until there is evidence of encouraging economic data. What I see in the data is a worsening condition on almost all fronts, including leading indicators. I believe it is the Bulls who are talking unrealistically at this point. I believe that Long Term Zero Coupon Bonds are the leading asset class this year, as far as total return. Furthermore, Bernanke is talking his book pretty openly. I believe that this site has had previous articles about both Bernanke and Greenspan and their nightmarish fear of deflation. Well, we may wind up in hyper inflation some day because of their actions today, but for now deflation fears seems to be everywhere, as we pay the price for years of excess and simultaneously take a strong hit demographically. It is really quite something to reread Bernanke's 2002 speech where he talks of what he would do in the exact nightmare scenario he is facing today. It is hard to imagine that he has had a change of heart. Taking Bernanke at his word, one must believe that the possibility of 2 1/2% or lower 30 Year yields is a reality. And as we struggle for return, it is interesting to note the kind of return one could get by being long 30 Year Treasuries or Strips and having this scenario play out. It certainly seems more realistic to me than the S&P climbing to 1400 at this point in time, and the return on Treasuries if yields fall significantly would be similar to that event taking place (S&P 1400).

"Here are excerpts from Bernanke's speech.

Bernanke's Famous 2002 Speech - Deflation: Making Sure "It" Doesn't Happen Here:

"Sustained deflation can be highly destructive to a modern economy and should be strongly resisted. Fortunately, for the foreseeable future, the chances of a serious deflation in the United States appear remote indeed, in large part because of our economy's underlying strengths but also because of the determination of the Federal Reserve and other U.S. policymakers to act preemptively against deflationary pressures. Moreover, as I have discussed today, a variety of policy responses are available should deflation appear to be taking hold. Because some of these alternative policy tools are relatively less familiar, they may raise practical problems of implementation and of calibration of their likely economic effects. For this reason, as I have emphasized, prevention of deflation is preferable to cure.

Nevertheless, I hope to have persuaded you that the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit its zero bound.

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure-that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period.

Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time-if it were credible-would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well."

There is much more of interest in this speech. The key thing is that Bernanke basically tells us that flattening the Yield Curve is the only approach that can work and since Fed Funds are not going to be raised, it follows that the long end of the curve must continue to come down. I realize there are those who scream "bubble" and "Carry Trade" but I think the B word is being ridiculously overused today.

David Fuller's view Many thanks for this considered email and congratulations on the success that you have had with your Treasury positions to date.

Having detailed my own views on bond markets at these levels - mainly that an unsustainable feeding frenzy is occurring and that it will end badly, I am quite happy to post the opposite view from a studious subscriber who has ridden this trend successfully. And to repeat my own position: I have small short position in US T-Bond futures which is losing money, so I have certainly not read this trend anywhere near as well as you have.

As a subscriber who has also attended The Chart Seminar, you will recall the emphasis on tactics and the importance of planning ahead, so that you can bank most of what you have made when the trend change eventually occurs. You mentioned that "you will continue to buy off of corrections until there is evidence of encouraging economic data." My only suggestion would be to combine that with a price-based study of the trend, possibly including trailing stops, in case the market moves more quickly than economic news which usually lags.

Bond markets now show every sign of being driven by a self-feeding momentum move. This has been encouraged by Bernanke's recent statements but yields may even be moving in advance of his expectations or wishes. The puppeteer may no longer be controlling the strings, in which case market dynamics may have taken over, potentially in a manner leading to a Type-1 accelerated bottom for Treasury yields.

Here are two related articles from Bloomberg:

Bond Market Bulls Thumb Noses at Pimco's Gross: David Pauly

Ultra-Low Bond Yields a 'Double-Edged Sword,' Wells Fargo Says

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