Well? Why Are You Short Treasuries?

In response to my last post on the S&P “downgrade,” Matt asks, “Well?  Why are you short treasuries?” Fair question. A couple very simple reasons (with slightly detailed explanations).

First off, this is not investment advice!

Now that I really think it through, there are actually two and a half reasons I’m short treasuries. The first two reasons are based on my market outlook and expectations of monetary policy. I’ll start with these.

1.) Short term interest rates have essentially been at zero percent since December 2008. That’s more than two years, and is unprecedented. Given that we experienced an unprecedented recession (unprecedented at least in recent memory), sustained low interest rates were absolutely the correct policy. In fact, according to Paul Krugman’s back of the envelope calculation using CBO estimates of unemployment and GDP growth, we should continue to see near zero interest rates until the end of 2013. And his reasoning makes sense to me.

Here’s a chart to put the short-term interest rate levels in perspective:

ChartObject Federal Funds Rate History (Effective Rate 1955 - 2008)

But the key here is that eventually rates will have to rise as the economy begins to heat up with all of this cheap money floating around. I have no idea when that will be, but I do know that rates won’t go much lower. And since bond (treasury) prices are inversely related to interest rates, unless the interest rates turn negative (which is extremely unlikely – that would mean cash would yield a higher return than treasuries), the prices of short term treasuries are effectively up against a ceiling. There’s plenty of room for prices to go down (as rates rise), but not all that much room to go up.

And the market won’t move based on when interest rates actually increase. It’s going to move based on when people expect that rates will increase in the future. But then what about when people expect that people will expect that rates will increase in the future? And then what about when people expect that people will expect that people will expect…that’s why the market’s so unpredictable. But I do know that at some point somebody’s going to expect something. And it hasn’t happened yet. So for a while I’ve kept my eye on shorting treasuries. Which brings me to point number two.

2.) The Fed has been experimenting with an unconventional form of monetary policy called quantitative easing (or QE for short). It’s a fairly intimidating name for the relatively simple act of buying treasuries with longer maturities than t-bills (that’s not to say that the decision of which treasuries to buy is simple). The Fed traditionally only sets short term interest rates, which is primarily accomplished by maintaining Fed funds rate targets. The idea of QE is that if the Fed can increase demand for treasuries with longer maturities, prices will increase and longer term interest rates will decrease below where they otherwise would have been. All else equal, lower long term rates is expansionary and should help speed up the economy.

There’s also a bit of an expectations game here too (if the Fed signals that they will buy long term treasuries, the market will price most of it in before they even do, so then they won’t need to actually buy them, but then they’d lose signaling credibility, so they buy them anyway), which isn’t as relevant so I won’t get into it.

So where does that leave us? Well, the Fed has been buying a ton of treasuries over the past couple years, further driving up the prices of treasuries at all positions on the yield curve. Here’s a chart showing Fed ownership of treasuries at different maturities as a result of QE:

The Fed has signaled (but not openly declared) that there won’t be much more quantitative easing, and that means that eventually the Fed is going to want to unwind at least some of these positions to decrease the size of their balance sheet (and reduce their own exposure to rising rates). This will have the opposite effect of QE — instead of increasing demand and thereby driving treasury prices up, now the Fed will have to increase supply as they get out of these positions, driving prices down. In fact, even without selling any treasuries, if the Fed just stops buying, this should also drive prices down since demand would decrease. This decrease in prices would likely happen as a result of supply and demand even if interest rates stay constant.

So the combination of these two points — that the sustained low interest rates have to rise at some point and that the Fed isn’t expected to continue driving prices up by buying longer-term treasuries (and may even sell some) — gives me two good reasons to short treasuries. One’s based on an interest rate expectation, and one’s based on a supply and demand expectation.

And now to the half reason, which is actually related to my post yesterday on S&P. As I mentioned yesterday, I think S&P’s decision to change their outlook was a bit ridiculous. But it still happened. I also think the equity market reaction was a bit ridiculous. But that still happened too. Now we go back again to the expectations game. If people think the government might default, regardless of whether or not it’s a rational thought, default risk could be factored into the price of treasuries, which would drive the prices down. To me this is the weakest of the arguments to short treasuries — it’s essentially a bet on the market panicking — but it wouldn’t be the first time.

And since the best way (that I can think of) to take advantage of these three expectations is to short treasuries, that’s what I’ve done.

Again, this is not investment advice!

Congratulations Mr. Lieber, I think you just unintentionally got me to write one of my longest posts ever! And I was planning on writing a boring and dry post on blues hip-hop fusion. I suppose that will have to wait until tomorrow.