FOMC Throws a Wrench in the "Short Treasuries" Trade

Yesterday's press release from the Federal Open Market Committee caught some market participants by surprise with the committee's decision to increase the size of the Federal Reserve's balance sheet by another 50% to more than $3 trillion.

Over the past several months we've heard repeatedly from the various regulators and authorities in Washington that they'll be using all the tools at their disposal to deal with the current crisis. Today's FOMC statements support those claims. Catching many off guard, the committee announced that it has decided to purchase up to $300 billion of longer-term Treasuries over the next six months. According to the release, these purchases are aimed at "improving conditions in private credit markets." However, we could also speculate that the Fed's aim is to keep Treasury yields near historic lows in anticipation of the massive slug of Treasuries it will need to issue later this year to finance its various stimulus and recovery programs. We're not suggesting that this is in fact the Fed's motive; rather our aim is to foster debate and discussion. In any case, the Fed's purchase of Treasuries is an unprecedented move that shows that Bernanke and company are willing to do whatever it takes to revive the economy.

Back in December, we floated the idea of taking a short-position in U.S. Treasuries when the 10-year bond was trading with a yield of about 2.65%. (See "Are Treasuries in a Bubble?") We never pulled the trigger however, as prices didn't quite reach levels (below 2%) that we were comfortable with in order to make the trade. To make a long story short, we think it is very difficult to build solid conviction in such a trade, considering the event risks that abound. Yesterday's announcement from the Fed is exactly the sort of thing that can turn a well-reasoned investment thesis on its head.

The new reality for investors, at least in the near to midterm, is that government intervention and involvement cannot be ruled out (or relied upon). For the investor who did bet against a fall in longer-dated Treasuries via  UltraShort 20+ Year Treasury ProShares (TBT), the announcement might have been a bit of a disappointment. In response to the news, TBT dropped nearly 10% for the day. Also, the yield on 10-year Treasuries plunged almost 16%, to 2.53%. (It opened on March 18 with a yield of more than 3%). This begs the question: How confident can we really be when we're playing in a game with constantly changing rules?

We continue to believe that there is in fact a bubble building in the U.S. Treasuries market. However, we lack the conviction to act due to our belief that events beyond our control (i.e. more government action) could strongly influence our investment's performance. Without question, the policies coming out of the Fed have long-term inflationary implications. We could also argue that the U.S. dollar could lose its status as the reserve currency down the road (or at least weaken considerably) as a result of the mess we're currently in or that investors will jump back into risk assets (thereby driving the yields on Treasuries higher). While these three factors support our thesis that Treasuries look frothy, there is still too much uncertainty around potential policy decisions and the timing of those decisions for our taste.

Of course, we could be wrong. Intrepid investors shouldn't be deterred altogether by our cautious stance--every investor's situation is different. Surely there is plenty of "smart money" out there looking to short Treasuries. Warren Buffett, the famed CEO of  Berkshire Hathaway (BRK.B), even stated in his most recent shareholder letter (on Page 16) that, "When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary."

Other ETFs--besides the TBT--that offer exposure to long-dated Treasury securities and could be impacted by today's developments include iShares Barclays 10-20 Year Treasury Bond (TLH),  iShares Barclays 20+ Year Treasury Bond (TLT), and SPDR Barclays Capital Long Term Treasury (TLO).

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