Thursday, August 27, 2009 17 comments ++[ CLICK TO COMMENT ]++

I'm thinking of betting on the US long bond... anyone think the risk-reward is reasonable?

I'm thinking of taking a position in US long bonds through the TLT ETF. Anyone have any thoughts on it? Last time I bet on the long bond, I lost money. The interest rate call was correct but the US$ decline caused losses. The situation is a bit different now.

This could be the dumbest idea ever... it's certainly risky. The only positive is that it is very contrarian. Being contrarian for the sake of contrarian is not always profitable, but is this different?

The thesis for the investment is a bet on deflation. Almost everyone, including superinvestors such as Warren Buffett are betting heavily on inflation, but is it possible that they are all wrong? I have been researching the issue for a while (I'll write up some blog entries on various ideas related to this over the next few weeks.) The case for deflation isn't solid but neither is the inflation view.

Any thoughts?


17 Response to I'm thinking of betting on the US long bond... anyone think the risk-reward is reasonable?

August 27, 2009 at 5:58 PM

I guess you could make a quick 30%+ if TLT goes back to where it was late last year.  And, if we get another round of debt deflation, deflationary scare, what-have-you, the market should fall out of bed and TLT is likely to rally.

Still, you're not paid much to wait and TLT seems overbought by some measures.  Plus, there's just so much supply of all sorts of US Goverment debt and even more to come.

I don't know; this doesn't seem like a no-brainer to me.


Good luck with whatever you decide to do.


August 28, 2009 at 6:41 AM

Deflation scenario for bonds has yet to begin.  You need to be following $TNX for yield direction and not intuition.  As long as $TNX is above 34.30(3.43%) bond yields are headed higher and TLT will top out.  Deflation would not normally start until yields are below 3.30% (33.00) on the ten yr and TLT may not make this height at this juncture.  Such a bet would be anti-US stock market and is this your intent?  Such a bet would be bullish the US Dollar and is that your intent?  Oil might de-couple??  However, the aussy dollar tracks the $SSEC like a glove and both may decline and is this your intent?  Simple solution - wait until TLT pulls back to its 18 day moving average before buying which is a better buy if you are right.  If you are wrong, you will only lose half as much as it declines further.  JoelDee/Berlin

Sivaram Velauthapillai
August 28, 2009 at 10:17 AM

This is definitely not a no-brainer. But then again, I hate I don't think anything can be said to be a no-brainer in advance--at least based on my experience.

I think you are right in suggesting that this has big downside while the upside is kind of low. So this is asymmetric to the downside :(

It's just an idea at this point but I'm doing research...

Sivaram Velauthapillai
August 28, 2009 at 10:25 AM

Thanks for the thoughts JoelDee.

Are you a trader? I ask, because you pick the 3.3% for the 10 year yield but there is nothing fundamental about that point. I am not a technical analyst but I guess technical analysts may say it's a support. Is that why you picked that?

As for the TLT, why 18 dma? Do you find that more relevant in this case? I see most technical analysts use 30dma. Anyway, the 18dma is around 94 for the TLT. A safer entry would be something like 91 but that's very far from here.

As for the impact on other assets, yes, deflation will mark down most other assets. The most vulnerable are commodities (and basically anything that depends on a weak US$.) I'm not really sure how likely the deflationary outcome is in the near term so this is just an idea I'm investigating...

August 28, 2009 at 3:38 PM

What is your edge?

I am not a total believer in efficient markets, but you are talking about speculating (not investing) in a HUGE financial market with lots of very smart players.  What do you bring to the table that makes you feel confident of you have an edge playing the bond market?

August 28, 2009 at 6:11 PM

The risk/reward on such a trade seems to be very badly skewed. On the one hand, nominal interest is pretty low at the moment and only a move to Japan-style conditions would generate the potential for good returns. Those returns woud still be capped as nominal interest cannot go below zero. On the other hand, getting completely slaughtered is easily possible if serious inflation expectations take hold.

Perhaps crucially, even with deflation you can get butchered on this. We are in serious deflation but this hasn't stopped the bond market from bidding yields to extreme real yields. On balance, risk/reward seems unfavorable.

Now wtf is going on with ABK? I dumped at the open today grateful for a chance to get out with a good profit even though my thesis appears to be quite wrong. The again, in a market where LEHMQcan jump 200% and even MTLQQ has trtaded above $1 recently I suppose no reasons or rationality are needed.

August 29, 2009 at 1:37 PM

I have been looking at bonds myself lately, mostly because I have cash sitting around and I hate not earning anything with it.  

We have had a good little rally in bonds lately and personally I feel it is a little too late to be jumping in, especially for a small investor who cannot use long-term bonds as a hedge against some other exposure. 

I am also staying away from the long-term because I believe the Fed will do everything it can to fight deflation.   You might get a gain  from here but the intention of policy is to eventually move those long-term yields higher.  

Also, as a fellow Canadian, we have to be conscious of the currency risk.   I have been bearish on the US$ for quite a few years now and am not changing my stance here.   The upside for the loonie might be limited, especially if natural gas prices stay low,  but I doubt if 5, 10 or 20 years from now, it will be lower against the US$

August 29, 2009 at 6:29 PM

Good question but here is how I look at it... it's just my opinion and it's not a proof or something I can be certain it... feel free to challenge what I"m saying because it improves my thinking :)

The situation is no different than any other investment. It's speculation more than an "investment" because it's a macro bet. All macro bets are speculation in my eyes. After all, if someone bets on, say, China today, that's speculation too. There is no way one can be certain China will turn out well.

Ignoring pure value investing (where you buy way below asset value or liquidation value or stuff like that), I think your question, about what one's edge over the professionals is, can be asked of any investment out there. Even with a simple common stock investment, what is your edge? Let's say you do your analysis, come to the conclusion that Coca-Cola is a good investment and go and buy it tomorrow. What's your edge? Every transaction has a seller. So what do you know that the seller does not? The seller is likely to be a professional, who does this for a living, is probably just as smart as you, has studied the markets as long as you, and so on.

So, going back to hte bond idea, I think the edge that you have is the same as you, as a small investor, always did. Namely, you can invest whenever you want, however you want, and as long as you want. The main edge you can with this idea right now is that it is mostly contrarian. Almost everyone is on the other side of the trade so you have an advantage. This doesn't mean you will necessarily make money (if you are wrong, you will lose money) but it does give you a small edge...

August 29, 2009 at 6:46 PM

I assume you are ContrarianDutch, right? I'm glad that you got out of Ambac safely. At least someone out there navigated safely out of the disaster known as Ambac.

The bond bet is indeed skewed but the market moves slowly. Unlike individual stocks, one can limit their losses if they wanted to. One can, say, take a position and exist with a 20% loss if they think they are wrong.

The market seems very speculative. I was looking into this and was going to write a post but don't know if I'll have time to research it much. I don't have enough experience so I don't know if what we are seeing is typical near the start of (cyclical or secular) bull markets (2002/2003, 1982, 1974, 1948, 1932, etc). There are news stories suggesting that almost 40% of the NYSE volume is due to a few distressed firms such as Citigroup, AIG, Fannie Mae, and so on.

Ambac looks weird but have you looked at AIG? Wow. It's up 100% for the year and around 500% since the bottom in March. Same with Citigroup. Everyone thought these companies were insolvent but maybe not. Who knows.

The thing I notice is that volume has been really high in August (and July to some extent.) Maybe it's traders and money managers returning from vacaction but whatever it is, I have never seen anything like it. But then again, the massive volume resembles most major bear market bottoms. Based on my look of bottoms in 1932 & 1933, 1942, etc, you get high volume off the major surge from the bottom. Then the volume dies down and the market usually goes sideways (at least for many months.)

So the trading seems to indicate a major (multi-decade) bottom. The sell-off in govt bonds also supports this view. But, on the other hand, the market never hit very low valuations. All major bear markets (deflation or inflation or anything else) have hit very low valuations. This is why I'm not confident that future returns will be high.

August 29, 2009 at 7:02 PM

My impression is that you share oppositive views from me. You are bearish on the US$ and are probably in the inflation camp. If so, you definitely should not consider long bonds or any US govt bonds for that matter. Even if your cash is earning nothing, it will be much safer than US govt bonds, which will post losses if inflation sets in, or if the US$ declines.

I have a more favourable view towards USA and that's why I'm considering the US govt bonds. Although the US$ may decline against the C$ (maybe), I don't think it will materially decline against the Euro or Latin American countries. As for Asian currencies, that's driven almost solely by political decision than market forces. So, overall, I think the US$ will stay strong. But I should note that I lean toward deflation. If we get inflation, the US$ will weaken.

I am more bullish towards the US$, not because I expect its economy to be booming or something, but because it is more capitalist and is more stable. For instance, China can easily run into serious problems (similar to what USA faced in the 30's or, to a minor degree, what Japan faced in the 80's) and cause all sorts of the problems for other countries. The US$ in such a scenario will remain stable to strong.

However, in a pure free market, the US$ will probably decline in the long run because it is uncompetitive. But there are too many distortions to invest based on that.

A good test to see if any of our theories are correct is to watch the gold market. Gold, amazingly, has literally gone nowhere in almost one and a half years. If someone could have predicted the stock market crash, the collapse of Lehman, fall of AIG, massive liquidity injections, etc, they probably would have said that gold would skyrocket. Yet it never surpassed the peak it set in early 2008. Even when high inflation was in the press in the middle of 2008, when oil was skyrocketing to $147, gold didn't surpass the peak it set in early 2008. Gold is up around 12% this year but it remains to be seen how it closes out the year...

Daniel M. Ryan
August 30, 2009 at 2:21 AM

" Gold, amazingly, has literally gone nowhere in almost one and a half years."

I think gold has gone nowhere because of fears of deflation; that's consistent with the T-bond run-up during the recent crisis. Gold won't go anywhere unless there's a new resurgance of inflation.  

August 30, 2009 at 2:49 PM

Yeah, you are right: gold probably got killed because of deflationary forces. But the thing is, some people argue that gold will do well in deflation. They cite the 1930's when gold in America did well (it was banned in 1933 so it depends on how you measure it but overall it outperformed if you look at international markets or against other assets.)

August 30, 2009 at 4:26 PM

Why would an investor care about a "pure free market" because "pure free markets" only exist in the imaginations of some academic economists.

Sorry, but I am not in the inflation camp.  I believe the deflationary forces are very strong.   But I also know the Fed, and others, will do everything they can to prevent deflation. Betting against them is very high risk.  

To day that gold has gone nowhere in the past year and a half is to selectively select the high point for gold in the past 2 decades and say that is solely what it should be measured against.  It has also tripled in US$ terms in the past 5 years or so.

I own no gold, and do not know how to value it, but it is probably a safer bet than long-term US treasuries.


Daniel M. Ryan
August 30, 2009 at 4:37 PM

Yes, gold did do well. You can even see it in some of the old claim maps in Ontario. Around the area where the old Hemlo mine was [ ], there were a lot of claims filed in 1930 and 1931 before the big strike in '78-9. I think it was James Dimes who pointed out, 'way before I was born, that if you charted the Dow Jones and the gold miners' index from 1929 to 1933, you would get an 'X'.

It wasn't deflation that did it, though, it was the gold market discounting an anticipated devaluation. [Said devaluation took place in 1933.] When disinflation came along in the early 1980s, gold got slaughtered. At that time, the U.S buck was pure fiat currency and floated with respect to gold.

August 30, 2009 at 5:33 PM

CapitalistRoader: "<span>Why would an investor care about a "pure free market" because "pure free markets" only exist in the imaginations of some academic economists. "</span>

<span>There isn't anything that is a "pure" free market but I like to separate something that is closer to a free market from one that is very far from it. I make the distinction because, in something that is closer to a free market, it is largely driven by supply & demand and rational profit-maximizing decisions. This doesn't mean people won't make mistakes (house bubble for example) but it does mean that ecoomics works for the most part.</span>

<span>In contrast, in a market that is largely driven by political decisions, the outcome can be almost anything. It's very hard to forecast the outcome to any confidence if market participants are not seeking to maximize profit.</span>

<span>Coming back to the US$, I think it is important to realize that a lot of investors, especially central banks in China and Japan, invest blindly into US$-denominated assets (mostly Agency bonds and Treasury bonds) with no expectation of profit. These are mostly political decisions and so the market isn't quite "free". I think such a market will behave very different from one that is more free-market-oriented.</span>

<span>"Sorry, but I am not in the inflation camp.  I believe the deflationary forces are very strong.   But I also know the Fed, and others, will do everything they can to prevent deflation. Betting against them is very high risk.   "</span>

<span>Aren't you basically implying that inflation is the outcome here? You are admitting the deflationary forces but, at the same time, are suggesting that the FedRes and other central banks will do everything and is risky to bet against them. </span><span>The question is, does this mean that you think the central banks will succeed or not? The way I read what you are saying, you think they will. </span>

August 30, 2009 at 5:33 PM

<span>"To day that gold has gone nowhere in the past year and a half is to selectively select the high point for gold in the past 2 decades and say that is solely what it should be measured against. "</span>

<span>Yes, I picked specific points but that is with a purpose. The reason that was picked was because the financial collapse, and the massive money printing/govt lending/whatever, occurred in that period. Gold did not budge. In a rough sense, this probably means gold fears deflation more than inflation--or doesn't see high inflation on the horizon.</span>

August 30, 2009 at 9:04 PM

I have though about it but this is may be a hindsigh bias. we think what happened late last year will repeat, it could but i am not going to waste capital on it. 

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