Long Bonds and Yen: Big Shorts for 2012?

  - Jeremy Grantham, GMO Advisors

As of this writing, the 30-year Treasury yield is a shade above 3%.

Who wants to lend to Uncle Sam for three decades at that rate? Apparently lots of folks.

The trouble with USTs, of course, is not the risk of getting your money back. It’s the risk of being paid in depreciated dollars. In a recent preview of his annual letter, Warren Buffett declared bonds “among the most dangerous of assets,” adding that “right now bonds should come with a warning label.”

The full Buffett quote (emphasis mine):

"Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control."

Buffett echoes the sentiment of Jim Grant, who likes to quip that, rather than offering risk-free return, U.S. Treasuries now offer “return-free risk.”

Weirdly enough, the bearish story for long bonds is linked to the bullish recovery scenario for the global economy.

If the world continues to look terrible — caught between the Scylla and Charybdis of sovereign risk and deflationary forces — then USTs will continue to function as a grudging safe haven. There is just too much capital sloshing around out there, and too few shelters from the storm.

If a recovery mentality truly takes hold, however — and affirms itself in the data — then the desire to hold treasuries could evaporate. Accelerating economic growth, against a continued backdrop of expanding credit and loose monetary policy, could force investors to dump their low-yield UST holdings like last season’s reality show star.

Not to mention the abundance of increasingly attractive alternatives to Uncle Sam, even for nervous ninnies. A safety-seeker looking to park cash these days might be better off lending to Brazil, or Canada, or any number of blue chip multinationals… all of which have pricing power and growth participation (through agriculture, energy, global sales etcetera).

What could keep bonds strong and yields low? Basically, fear and deflation.

The Treasury bull case is twofold: 1) Growth will continue to suck, 2) Europe will continue to terrify. Elaborate arguments for owning USTs boil down to historical evidence for deflationary bias in heavy-debt-overhang, post-credit-bust environments.

One thing is clear, though: At some point bonds are going to go tapioca, because rates can’t stay low forever. (Nor can a printing press run to infinity.) Our focus isn’t to predict the timing of the bust, but to make sure we’re there when it happens.

To that end, the long bond chart raises an eyebrow…



In a related “government folly” department, another enticing big short candidate for 2012 is the Japanese yen.

To put it simply, Japan is a demographic time bomb. The insanely leveraged Japanese financial system is internally funded. Japanese Government Bonds (JGBs) are such a lousy proposition that only Japanese savers (and Japanese institutions) still want to buy them - and many savers buy without knowing it via institutional proxy.

But at some point - an unknown tipping point - Japan’s savers will morph into spenders as Mrs. Watanabe hits her golden years. When this tipping point comes - or flight instinct kicks in via anticipation of its arrival - the retiree savings flows that prop up the JGB market slow down or even reverse. From there it is only a short period of time (a downward spiral really) before Japan loses the ability to service its massive interest payments.

When this eventually happens, as the law of gravity argues it must, you get a case of what the IMF calls “exploding debt dynamics” - a phrase Argentina is all too familiar with. For a country with sovereign control of its currency - something Greece wishes it had but does not - the only way around such a disaster is to print like mad, i.e. “Kick it Weimar Style”…. in which case the yen gets vaporized.

The storm begins with a small gust of wind. And what have we here, via Marketwatch:

"In a surprise move on Tuesday, the Bank of Japan expanded its asset-purchase program and set a temporary inflation target of 1%, while keeping interest rates near zero.

…The additional easing came as a surprise to the market, with a Dow Jones Newswires survey of economists ahead of the announcement showing expectations for no new action from the bank."

The chart below shows FXY, the Japanese yen currency shares ETF. For expressing a trade, either Japanese yen futures or the forex vehicle USDJPY might be better… but FXY, being denominated in dollars, clearly displays the top.



Let it be said that bond bears and yen bears have been growling for a long, LONG time. The bearish Japan trade has even been called the “widow-maker” because so many traders have lost their shirts betting on a JGB implosion.

This is a natural function of how pessimistic macro predictions, and crisis situations in general, tend to work. Mr. Market has a well established habit of ignoring worrisome macro factors completely… until the day he starts paying attention, at which point all hell breaks loose.

Our 2012 strategy is two-fold: As a matter of preparation, we want to be Johnny-On-the-Spot if and when a “big trend” macro opportunity breaks wide open. We won’t obsess over bonds, yen, etc… but if the train gets to rolling, we’ll be on board. In the meantime, because the wait between “home run” style opportunities can sometimes be long, we’ll be focusing on bread and butter income generation with high probability swing trades — exploiting mean reversion tendencies and day-to-day market movements week in and week out.

Whether “risk on” or “risk off,” we foresee a great year ahead for traders… and a couple home run cuts (via bonds and yen) would only make it sweeter.