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Sunday, January 20, 2008 11:40 AM

Time To Short Treasuries?

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Kass Says Sell Bonds Short.

Kass: The bond market is in a bubble that is reminiscent of (and quite possibly as extreme as) other bubbles during previous eras. From my perch, the only issue is the timing of this trade.

Mish: Timing is indeed everything and perhaps there is a temporary selloff. But the primary trend is for lower yields. Perhaps much lower yields. There is no bubble in bonds. Not yet.

Kass: Surprisingly, today's 3.68% yield on the 10-year U.S. note is lower than the yield during the recession of 2001.

Mish: What's the surprise? The economy is in far worse shape, orders of magnitude worse shape in fact. In 2001 consumers stopped spending for a month. Debt ridden consumers will be out of action for months, perhaps years to come now.

Kass: This low yield appears to be artificially affected by a number of temporary and backward-looking factors.

Mish: Goldman estimates $200 billion in bank writeoffs are coming. We are well on the way. $200 billion in capital losses will impair $2 trillion in future lending because of fractional reserve lending. This is forward looking. Furthermore, I expect $200 billion is extremely conservative. I look for $500 billion minimum. $1 trillion, affecting $10 trillion in future lending would not be surprising if there is a cascade of derivative defaults.

Kass: Here are the principal reasons why I would short bonds now -- and with impunity. The economic stimulation is (or will be) coming from several directions:
1. The Fed has likely embarked on a lengthy period of aggressive easing.
2. The administration is planning a broad fiscal stimulation package, and the Democratic contenders are proposing fiscal relief and pro-growth messages.
3. The recent drop in the price of oil will likely be followed by a general decline in other commodities. These trends can be viewed as an effective tax decrease.

1. The Fed is indeed embarked on "lengthy" easing. Here is a key. The "lengthier" the embarking, the "lengthier" it is wrong to short treasuries. The Fed will not be embarking on "lengthy" easing unless conditions warrant it. I seriously doubt Bernanke wants to repeat Greenspan's mistake. I expect he will err on the other side in spite of all this helicopter talk.
2. The administration is indeed planning fiscal stimulus. However, Fiscal "Stimulus" Doomed To Fail.
3. A drop in the price of oil and commodities is supposed to cause inflation and cause a treasury selloff? This is a new one on me. But yes, I agree a drop in the price of oil is coming. It will come BECAUSE the economy is slowing. When commodity prices drop, it will ease inflation fears, not add to them.

Kass: There are fewer credit shoes to drop. The housing/subslime problems that have moved up the credit ladder now seem to be recognized by most. While counterparty risks with regard to credit default swaps should not be ignored, it is likely that few new problems will arise that are as consequential as those that mired the markets over the last 12 months. Consequently, the flight-to-quality trade might be about over now. As well, improving TED spreads and a lower Libor are moving in a direction that suggests the credit woes are lessening.

Mish: Subprime resets will hit full force later this year. That will be followed by Alt-A impacts and Pay Option Arm Impacts. Those will be compounded by collapsing commercial real estate prices that have just begun and will linger on for years just as "subprime" did.

Indeed Commercial Real Estate Dominoes Are Collapsing. Also on the Commercial Real Estate front please note that a Glut Of Mall Space Headed Our Way.

Furthermore, Credit card defaults are soaring as noted in Credit Card Defaults move to Forefront of Deflation Debate. Almost none of this is factored in. There are so many credit shoes dropping now, I do not know how anyone could miss them.

Kass: Suppose my economic fears are exaggerated and don't come to pass. A deep recession is now likely priced into bonds. If my friend/buddy/pal Brian Wesbury is correct and the economy doesn't fall into recession, bonds will get destroyed. Even a relatively shallow recession could now produce a rise in interest rates against current levels.

Mish: "Suppose my economic fears are exaggerated and don't come to pass." What economic fears are those? But as long as we are supposing, let's suppose a derivatives collapse sends yields to 1%. By the way. We are already in a recession so let's not suppose one won't happen.

Kass: Inflation is still an issue. Despite the Bureau of Labor Statistics' readings, inflation remains elevated and is not reflected in the current level of interest rates. The expected fiscal and monetary stimulation in the upcoming months will only serve to exacerbate inflationary pressures.

Mish: Before we can have a debate about whether or not inflation is a problem, we need to agree on what inflation is. Credit is being destroyed far faster than any monetary printing. Currently, Money Supply Trends Are Deflationary. In context of understanding what inflation is, treasury yields this low seem reasonable.

Kass: Central banks are diversifying away from U.S. government bonds. With the creation and proliferation of sovereign wealth funds, a growing portion of central bank reserves are being invested in non-bond assets. So, over time, central banks (especially of an Asian kind) could be lowering their U.S. bond purchases.

Mish: China is diversifying away from U.S. government bonds right now. It did not stop treasuries from rallying. Furthermore, the pent up demand for treasuries in the US is enormous. They are despised by nearly everyone here. This internal pent up demand can easily pick up any slack from reduced purchases by foreigners. 2.5% yields may looks measly, but not vs. 15% declines in the stock market. 30%? 50%? Most are severely underestimating the potential for enormous stock market declines here.

Kass: Momentum investors are exaggerating the bond price move. As with the situation in other commodities (gold, silver, energy products, etc.) from 2004 to 2007, I believe momentum traders are piling into the bond trade simply because it is working. This will not be a permanent issue. Momentum investors, as we have recently witnessed, are notoriously fickle and have quick trigger fingers.

Mish: Perhaps momentum is a factor. Perhaps not. Momentum is certainly a factor that once again pushed up high flying tech stocks to absurd extremes. As far as treasuries go, here are still more fundamental reasons for the rally: There is Grim News For State Budgets. Massive layoffs and decreases in state budgets are coming.

Unemployment is a lagging indicator. It was falling for years and just recently turned up. It has much much further to rise. Unemployment is Soaring as Private Sector Jobs Contract. With rising unemployment will come still more foreclosures on both residential and commercial property. This will further impair bank balance sheets and any presumed recovery from this so called $150 billion "stimulus". It will likely take months, before that money gets into consumer hands and perhaps a year before Congress figures out it is meaningless.

Virtually no one, including Bernake thinks deflation can happen in the US. My position is that Things That "Can't" Happen are about to. The result will be Deflation American Style.

Those looking for a bubble in bonds, need only look at corporates. Corporate defaults are going to soar, albeit from currently low levels. Please remember they said the same thing about "low levels" when subprime defaults first started rising.

Anyone who wants to short treasuries with impunity on this economic backdrop can be my guest. For the record, I have no grudge against Kass. He puts out a good column that I frequently agree with. However, I take the other side of this debate.

There is no bubble in treasuries if you look closely at the fundamental issues. Those who want to see how low treasury yields can get and stay there, need to look at Japan. Yields in the US are going to go far lower and stay lower longer than nearly everyone thinks.

Mike "Mish" Shedlock
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