Wednesday, May 18, 2022

Mea Culpa: We Got the Long Treasuries Call Wrong (Or Were Just Too Early)

Back in January, we wrote a post outlining our thesis for buying long-dated US Treasuries (and I did just that in my personal account). The main points of the thesis was that there was evidence that collateral was becoming scarce, a recession was likely on the horizon, and QT has historically resulted in yields on the long end coming down. That trade has, up to now, been a disaster. However, it is my view that the underlying thesis was correct; we were just early.

As MMT proves, US Treasury securities are not "loans" made to the US government. Rather, they are best thought of as savings accounts for large financial institutions and foreign countries. They are a place to park excess cash for a rainy day. They are a gift in the sense that they offer no credit risk and pay interest, typically at higher rates than those offered on reserves held at the Fed.

Treasuries are safe, liquid assets that have historically served as a safe haven during times of market stress and recessions, as investors view holding other "risk" assets as undesirable and would rather preserve their purchasing power.

What's been unique about the last few months, however, is the extreme scale of financial tightening caused by 1) the Biden administration's relentless push to lower the public deficit and 2) elevated commodity prices thanks to supply/demand imbalances, exacerbated by Russia's war in Ukraine. We've already written about how running surpluses drains reserves from the banking system, and is causing stress in financial markets. However, the energy/commodity market tightness has caused a dollar squeeze on foreign nations who import commodities, such as oil.

Case in point: let's take a look at Japan. The US dollar has been rapidly rising in value relative to the Japanese Yen:

Japan has the third largest economy in the world, yet is only about size of California. Its lack of consumable natural resources means that it must rely on importing energy and raw materials from other countries in order for its economy to function. The vast majority of global contracts for energy and raw materials are settled in dollars, which means Japan needs to acquire dollars in order to purchase the commodities that power its economy. They acquire dollars by selling goods such as automobiles and TVs to the United States. Because the US cares about taking care of its trading partners, we generously offer Japan the option to exchange surplus dollars into US Treasury securities, which are basically dollar savings accounts. For these reasons, Japan is the largest foreign holder of US Treasuries in the world.

According to the latest Treasury International Capital (TIC) data, since reaching its high-water mark of US Treasury holdings in November 2021, Japan has since sold $96 billion worth of Treasuries - a fairly substantial figure. Looking year-on-year, and its holdings have decreased by $8 billion:

This is because rising energy costs have made it more expensive to import raw materials (dollar USE goes up). At the same time, supply chain problems and chip shortages limit the sale of items like TVs and automobiles, two staples of Japan's export economy (dollar SOURCE goes down). This forced Japan to draw down on its dollar savings, i.e. its US Treasuries. It needs to sell Treasuries to raise dollars in order to meet near-term payment obligations for increasingly expensive commodities. This came at a time when the supply of dollars became more scarce, hence the dramatic move in USD/JPY (USD strengthens vs. JPY). Fortunately, the weakened Yen makes exports to the US more attractive, so there is a self-correcting mechanism at work.

In a sense, the weakness in US Treasuries is related to inflation, because prices have indeed gone up, causing an immediate need for dollars. But it's not because of investors intentionally dumping Treasuries out of fear for a loss of purchasing power they way that's described in Econ 101 textbooks; it is more mechanical/technical than that. Literally, Japan needs dollars and the easiest way for it to get more dollars is to sell Treasuries. Hence, Treasuries have sold off precipitously.

To reiterate, the spike in yields reflects a shortage of dollars needed to fund near-term obligations. This runs contra to the narrative that there are too many dollars which causes inflation, and that's why bonds have sold off. MMT shows us that adding dollars to the banking system/economy drives yields lower. The dollar shortage makes the cost/price (i.e. rates) of dollars go up. It signals market stress as liquidity is removed. This didn't happen because of Fed rate hikes; it happened because real dollars were removed from the banking system by the Biden admin, and rising energy costs further sucked out dollars from the global economy. A barrel of oil is still the same barrel of oil, it just costs more today than a year ago.

The initial reaction to the global dollar scarcity has been to sell financial assets of all stripes - both stocks and bonds. This causes stress and liquidity problems in the economy, which will likely lead to recession. That is when the bid for bonds will come.

So to conclude, we certainly got the timing on this call wrong, and didn't anticipate the impact on short-term commodity squeezes would have on the price of Treasuries. That being said, I have not sold a single bond, and am doubling down on this call. The bonds are cheaper, and there are more signs a recession is coming. There is talk among the institutional investor community about how government bonds seem somewhat attractive at these levels. Investors would be prudent to accumulate long-dated Treasuries at these levels. I also think shorting the front end makes sense as Jerome Powell seems determined to channel his inner-Volcker. So if the Fed surprises with rate hikes, that will likely further flatten and potentially invert the yield curve. For a pair trade, consider shorting SHY (iShares 1-3 year Treasury Bond ETF) and using the proceeds to purchase TLT (iShares 20+ year Treasury Bond ETF).

Disclosure: Long US Treasuries, short SHY

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