Why I am Short the long Bond

Currently I am short the 30yr U.S. Treasury Bond by being long the Exchange Traded Fund (ETF) TBT and short the ZB Futures contracts from ZBU09 (Front month Sept 09) as far out as ZBH10 (Mar 2010). I added to TBT this afternoon at 46.16 and 46.05 and am adding to the short futures position as I write this.

The case for the position:

1) Several foreign sovereign funds most notably China, but also including Saudi Arabia, Russia and others, have made public statements indicating a negative sentiment towards UST's in general and have reduced their overall positions.
In June 2009 after increasing their purchases of all treasuries every month for the previous year China reduced their position by $35.1 billion (3.89%), Russia by $4.6 billion (3.69%), and also of note the Carribean Banking Centers (4th largest foreign holder of UST's) by $5.1 billion (2.6%). The total outstanding UST debt between July and Aug 09 increased by $148.5 Billion but the foreign government participation only increased by $5.05 Billion. That's a reduction from 37.03 to 36.54% of the total outstanding.
2) Money flow into the shorter maturity treasuries (2-10yr Notes) between July 09 and Aug 09 increased by $91.2 billion while money flow into the 30yr Bond increased by $11.9 billion
3) Foreign holdings in the 30yr bond versus their total holdings of all UST's longer than 2 yrs decreased from 30% to 28.8%
4) Current levels of inflation are historically low due to actions of the Federal Reserve's Open Market Committee (FOMC) which has pushed the interest rates down and depressed the yield of the 30yr Bond. A return to mean levels would be a down force for the price of the 30yr and since inflation risk increases over time the 30yr is more vulnerable than shorter term maturity securities. Fears of the FOMC continuing to "print money" increase the fear of return to an inflationary environment, adding to perceived inflation risk.
5) Economic indications of a world wide recovery reduce the "flight to safety" trade.
6) Lower yields in the 30yr Gilt (London) and 30yr Bund (Germany) than the U.S. 30yr Bond indicate a lack of faith that the U.S. treasury is a more secure vehicle for the "flight to safety" trade. This puts downward pressure on the price of the bond.

The case against the position:

1) Japan, the second largest holder of U.S. treasuries after China, increased their holdings in June by $34.6 billion and Great Britain increased its holdings by $50.2 billion
2) The trend away from the shorter term maturity securities by both the Sovereigns and domestic purchasers. Between July 09 and Aug 09 outstanding Notes (2 to 10 yr maturity UST's) increased by 9.5% while outstanding Bonds (>10yr maturity, currently only 30yr are issued) increased by 13%
3) Foreign Government money flow between July 09 and Aug 09 into Notes increased by $54 Billion while increasing $256 billion into the 30yr
4) Certain indicators point to a continued environment of low inflation. Liquidity in the money supply as indicated by the M2 money supply metric has decreased for 4 straight weeks for an annualized rate of 12%. The St. Louis Fed's MZM money supply metric which is designed as a broad based indicator of liquidity has fallen at an annualized 16% over the same time. The ratio of the MZM to the GDP has dropped steeply and is at historically low levels indicating  a low velocity of money (the speed at which money changes hands) which is counter to the inflation scenario. High unemployment rates and a tight credit environment strengthen this position

5) Indications of a possible market correction in the near term remain and this would increase the "flight to safety" trade. Q3 earnings season could bring downside surprises and put pressure on equity prices. Low volume in equity markets during the recent upturn are worrisome. Prime mortgage delinquencies and defaults may put banks and derivative securities at risk. Housing markets remain depressed and with unemployment high the price of homes is likely to be under pressure for some time.

Potential spanners in the works:

1) Any large conflict in the world has the potential to be a "Black Swan" event, the Korean peninsula, the middle east, and the niger delta areas are potential hotspots where conflicts of a magnitude capable of disrupting markets.

2) The development of a "pan asian" currency would make a very powerful entity that might challenge the U.S. as a benchmark currency and debt denominated in such a currency would be a serious threat to the UST's.

3) Collapse of the US banking system due to second order effects of mortgage defaults, lack of fiscal discipline and excessive risk taking, and the effects of balance sheet write downs of known and unknown losses.

Conclusions:

The over representation of China in the holders of U.S. debt securities and their reticence to hold long paper trumps the inflow of money by the Japanese and British. I do not believe the Japanese nor the British can sustain the level of purchasing these securities to offset the outflow for very long, especially if the other sovereigns mentioned above continue to reduce their positions.

I believe the risk of inflation in the short term is still low but over the mid to long term is exceedingly high. Even a return to mean would be a significant down force on the price of UST's with the 30yr being the most affected.

A recovery in the Chinese and developing world that the U.S. lags is a real possibility which would be very bearish on the long Bond, and a recovery where the U.S. is an equal participant is only moderately less so.

While the "flight to safety" trade may still take place I believe there will be increasing tendency to seek that safety in foreign debt securities. I do not foresee any currency or national debt supplanting the U.S. Dollar, or the U.S. Treasury but any decrease in participation of the Sovereign buyers of this debt adds to the thesis. I also do not foresee the collapse of the U.S. banking system as a real threat, but the buyers of U.S. debt have to add this to their calculations when determining the level of their participation in the U.S. debt market.

Based on the above I feel the risk versus reward is very favorable and more so as I extend the time frame outward. Factors such as the price of the ETF or futures contracts at the time of purchase must also be evaluated to determine entry points. The price of the futures contracts indicates a market belief in my thesis as there is significant backwardation (the longer expiration contracts are cheaper than the front month).

This does not imply a specific recommendation to buy any securities, I do not know your circumstances and cannot evaluate the suitability of this investment for your individual situation.

References:
Link to Article in Chinese state run newspaper The Peoples Daily
As Liquidity Drains, so soes Inflation Risk (WSJ Subscription only)
Treasury Direct
The U.S. Dept of Treasury
The St. Louis Fed
Find Monthly Statements of the Public Debt here


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