Treasuries have reached bubbly levels, both in terms of low yield and the rate of change of price.

Interest rates will rise when the economy recovers, or when bond buyers demand more long-term interest to absorb trillions of new issues to fund recovery programs. Rising interest rates mean Treasury prices will fall.

Consider these charts plotting the interest rate on 10-year  and 30-year Treasuries versus the price of 10-year and 30-year Treasuries. Price and yield are near perfect mirror images.

The 19-year history of the monthly yields shows a steady decline, followed by a precipitous drop in Q4 2008. There is little room for further decline, and reasons to believe that rates must rise. Long-term investors, for example, cannot be expected to be content to earn 2+% forever.

Long-term history of rates shows there is much more room for rates to rise than to fall. We don’t know when rates will rise or by how much.

The Ten-Year T-Bond

The 10-year average interest rate for the 10-year bond is 4.68%, while the current rate is 2.18%.

click images to enlarge

10-Yr T-Bond Yield versus 10-Yr T-Bond Price

Yields are shown as a solid black line. Prices are shown as a dashed red line. The 10-year simple moving average yield is shown as a dashed blue line. The current 10-year average yield is indicated as a green horizontal line. The price range for Treasuries when yields were in the vicinity of the 10-year average yield is bounded by a green oval.

The Thirty-Year T-Bond

The 10-year average rate for the 30-year bond is 5.27%, while the current rate is 2.55%.

30-Yr T-Bond Yield versus 30-Yr T-Bond Price

The charts visually suggest a coming significant fall in the prices of 10-year and of 30-year Treasuries in a mean reversion as general business conditions improve.

Treasury Futures

Futures charts for the 10-year and 30-year bonds tell the same story. The relative strength index (RSI) shows an overbought condition for the 30-year bond and a recently overbought condition for the 10-year bond.

10-Yr T-Bond March ‘09 Futures (with RSI study)

30-Yr T-Bond March ‘09 Futures (with RSI study)

Recommendation:

For investors who invest only “long”, closing long positions in long-dated Treasuries, or being alert to a trend reversal necessitating the closing of those positions is recommended.

For investors who also invest “short”, being alert to a trend reversal creating shorting opportunity is recommended. The current trend is strongly upward, but could reverse dramatically if a Treasury auction brings higher rates. The decline in prices could be as sudden and precipitous as the rise, as the recent gap down in the 10-year futures contract hints.

In either case, whether holding long or short positions, we recommend using persistent trailing stops to minimize the loss potential, while letting profits run.

Investment or Trading Vehicles:

Stock investors can use exchange traded funds.  Futures contracts are available to those with accounts at futures dealers.  There are also Put and Call options traded on some of the Treasury ETFs through stock brokers.  On the long side only, there are low cost mutual funds available.

• Treasuries from 7-10 years are held by the ETF symbol IEF
• Treasuries of 20+ years maturity are held by the ETF symbol TLT
• Treasuries from 5-10 years are held by the MF symbol VFITX
• Treasuries from 15-30 years are held by the MF symbol VUSTX.

IEF has a 3-month average daily volume of 525,000 shares, and TLT has a 3-month average daily volume 2,924,000 shares.

Both may be shorted, but the inventory for shorting TLT is limited, making that impractical to impossible, depending on the broker used.

There are two double-short Treasury ETFs that can be held long to create the economic opportunity of shorting while limiting maximum risk to no more than the invested amount (compared to direct shorting, which in theory could put more than the invested amount at risk).

• PST for Treasuries with maturities of 7-10 years
• TBT for Treasuries with maturities of 20+ years.

PST has a 3-month average daily volume of 133,000 shares, and TBT has a 3-month average daily volume 3,258,000 shares.

Puts and Calls also have the advantage of limiting loss potential to the amount invested, but they are more volatile than the underlying security, and have an expiring time value, as do futures contracts.

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INVEST WITH CARE. Seek to reach your return objectives while managing your risk.

Richard Shaw
QVM Group LLC

This entry was posted on Wednesday, December 24th, 2008 at 10:04 am and is filed under Bonds, Market Conditions, Valuation. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.