I keep hearing that the so-called “smart-money” is betting big money that U.S. Treasury bond prices will head lower. The rumor mill has been spinning the story that hedge funds have taken massive short positions on Treasury bonds that will pay off when bond prices fall.
Now, I know, most investors don’t pay all that much attention to the Treasury market. And for good reason – there’s nothing fun or interesting about Treasury bonds. Bonds are about as boring as it gets.
For an investment geek like me, I love researching stocks because that’s how I get a profitable edge.
I read quarterly earnings reports and I pay particular attention to the transcripts from quarterly conference calls that companies host with analysts. Because when analysts start asking questions of a company’s leaders – and getting answers – this is where the golden nuggets are, the small clues that can lead to big paydays.
Plus, I know that most investors don’t spend hours every week digging through financial reports and conference call transcripts, so it’s time well spent.
For most investors, bonds are the “guaranteed” part of their investments. In a traditional 60/40 portfolio, 60% of your loot goes into stocks because that’s where the juice is. 40% goes into bonds so you don’t lose too much when the stock market goes kablooey.
Even though they tell you that you shouldn’t time the market, the mechanics of a true 60/40 portfolio actually are a market timing system. In a “boom-bust” system it’s pretty well established that the economy and the stock boom until something happens, and then it goes bust.
So as the 60% part of your investment portfolio goes booming higher, say to 65%, you’re supposed to take the 5% off the table and add it to the 40% side that’s dedicated to the safety of bonds. This is a very mechanical system for taking profits along the way. The #1 rule of investing is always BUY LOW, SELL HIGH.
Conversely, when the boom/bust cycle shifts to “bust,” stocks sell off and bond prices tend to rally. There’s a flight-to-safety aspect. Money that comes out of stocks has to go somewhere. And the guaranteed return from bonds makes them the best choice.
But also, when the economy tanks, the Fed will eventually step in and cut interest rates and that sends bond prices higher, too.
So when the 40% part of your 60/40 portfolio moves higher, the “rules” require you take the profits and re-allocate them to stocks. Which means that you’re buying low on stocks.
And so the 60/40 portfolio has been a very simple yet effective way to buy low and sell high for 50 years.
The Outlook for Bond Prices
The question here is: why? Why are hedge funds betting that Treasury bond prices will fall?
The U.S. economy is on fairly shaky ground right now. The general consensus is that we are right on the verge of a recession. The only real question is whether a recession will be mild or severe…
Either way, we can expect that a recession will send stock prices lower and bond prices higher. Betting that Treasury bonds will fall in price doesn’t make sense if you think that the U.S. economy is heading into a recession.
Because a U.S. recession would very likely lead to the Fed cutting interest rates sooner than currently expected. Lower rates would push bond prices higher, not lower.
The mini-crisis in regional banks is another potential catalyst for bond prices – an upside catalyst. Pretty easy to see the “flight to safety” trade here. Money coming out of regional bank accounts could be expected to find a home in the bond market, thereby pushing bond prices higher…
And in fact, bond prices did gap higher in early March when Silicon Valley Bank got the whole regional bank crisis going.
Here too, if you think the regional bank crisis is going to get worse, it doesn’t make any sense to bet that Treasury bond prices will fall. In fact, the opposite – higher bond prices – is the way to go.
There’s only two scenarios that lead us to lower bond prices.
The first is more rate hikes by the Fed in response to inflation. I’ve spoken my mind pretty clearly on this – I think the Fed is on “pause” for the foreseeable future and I think the trend for inflation is lower.
I suppose there’s an argument the Fed could drop another rate hike or two but I don’t think it’s a very good one. And I certainly don’t see why anyone would bet actual money on that…
Which leaves me with one catalyst with a pretty reasonable shot at send bond prices lower…
Betting On Congressional Dysfunction
By now, we all know that the Federal government will run out of money in a month or so. And we also know that both sides of the aisle are more than willing to hold the good faith and credit of the United States hostage to score political points.
And we’ve already seen a few analysts and even the Treasury Secretary Yellen slap together Powerpoint presentations illustrating the calamity that awaits if the debt ceiling doesn’t get raised and the U.S. actually defaults on its debt…
A massive stock market sell-off, a brutal jump in unemployment, a gut punch to lending (especially for those regional banks) – and yes, a giant spike for bond yields and a collapse for bond prices…
Of these, a drop in bond prices is the most certain. The entire reason the U.S. can borrow money (ie, sell bonds) at the low rates it does is because of the ironclad guarantee that anyone lending the U.S. money will be made whole.
Remove that assurance and lenders would absolutely demand a higher interest rate.
But the scary part (to me anyway) is the ease with which the powers that be, the smart money, the hedge funds and the political insiders can use social media, the financial media and the mainstream media to blow this whole debt ceiling thing into a full on panic.
The default drumbeat is going to get louder. There’s gonna be a conga line of strategist-types lined up for their 60-second spot on CNBC to make sure we all understand how dire the situation is…
Editorials, articles, podcasts and tweets – I foresee a full court press to foment fear and crush bond prices.
And of course, the smart money and hedge funds will cash out right before an 11th hour deal is done and laugh all the way to the bank. As usual…
Chief Investment Strategist
Pro Trader Today