Before the FOMC decision: is it Time to Short Bonds?

June 16, 2015, 10:40 am ET, BY Thomas H. Kee Jr- Editor, Stock Traders Daily| Editor: Thomas H. Kee Jr. (Follow on LinkedIn)

It has been a widely held belief for years that shorting the bond market would eventually be a great longer term investment.  After all, as they put it, Interest Rates can't stay this low forever!

The text from the FOMC decision tomorrow will likely indicate that the FOMC will raise interest rates the next time they meet, at least this is the expectation of Wall Street given employment and inflation data recently, and unless that changes the FOMC will most likely stay the course.  I also believe there is a slight chance they raise rates on Wednesday, although it seems like a stretch in the face of the Grexit risk and the pressures from world organizations to actually wait until 2016.

Either way, the time has come for rates to start to increase, and those short sellers of the bond market certainly feel like their time has come as well.  The best way to short the long term Treasury Bond market, in my opinion, is to use ProShares UltraShort Lehman 20+ Yr(ETF) (NYSEARCA:TBT).  This ETF is trading near $50 now after having bounced from the $40 range twice this year already.  That means it is up about 25% from its 2015 lows, exemplifying the volatility in the bond market that we are already aware of.  That begs the question; does this short based ETF still have room to increase?

Short sellers of the bond market would argue that it does.  They would suggest that as prices adjust to higher interest rates (inversely) TBT will continue to appreciate.  In a world where all that impacted the demand for Treasury Bonds was interest rates I would generally agree, but that's not the sole influence, so let's look at recent history to prove that interest rates are not the only influence.

The FOMC slashed rates to near 0% in December 2008, and at that time TBT was trading near $160.  With rates held steady near 0 for that entire time, TBT deteriorated, reaching a low of just under $40 this year.  There was no change in the Target rate of the FOMC during that time, but interest rates in the open market changed dramatically.  The rationale lies in the demand side of the equation.

What we have known since 2008 is an environment where the FOMC was actually 'printing money' to buy bonds and influence rates even lower than their rate cut had already done.  The fabricated demand for bonds is actually what caused the bond market to rally as aggressively as it did, so interest rates are not the only influence on the bond market. 

That begs the question, what can influence the demand side of the equation for long term US Treasury bonds now?   To this point a few things are clear.  First, the FOMC is no longer buying bonds except as they reinvest interest and maturing holdings, so that reduces demand, but at the same time Europe has engaged aggressive stimulus programs of its own and many institutions consider the US Treasury bond market to be the best game in town with respect to both safety and yield.  That could influence the demand side positively and largely offsets the FOMC's current impact.

In my opinion these forces are largely offsetting each other, a slight edge must be given to the influence of the FOMC, but there's more, and I already alluded to it.

Certainly central banks have played and are playing a role in the demand for bonds, however, if the sanguine perception of the economy today changes and investors start to become concerned that economic pressures and the lack of stimulus and monetary policy support, including of course higher interest rates, could cause asset prices to come down or collapse, money flows will naturally turn to the safe haven of the US Treasury Market again and add a bid to the bond market that is not there at this immediate time.  That means bond market buyers would surface even in the face of a rate increase by the FOMC.  They could even perceive that if asset prices decline the FOMC will not be able to raise rates more than only a very little.

Because my Macroeconomic work, The Investment Rate, tells me that a declining asset environment is absolutely coming I think shorting the US Treasury Bond market is a very risky bet at these levels.  TBT could very well fall back to $40 again, but if the greed that seems to dominate the stock market today turns to fear and then to capitulation the demand for bonds could actually cause TBT to fall even more than that.  This time, however, the demand would not be from fabricated dollars.

Recommendation:

For a detailed Recommendation access our Special Reports, and there you will find a special report dedicated to this observation.  That report will include not only the analysis above, but additional buy or sell recommendations for TBT and TLT as well as access to the macroeconomic work that underlies our outlook for asset prices.  Special Report

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