Daily Gains Letter

Sell-Off in the Bond Market Imminent?

By for Daily Gains Letter |

Bond Market ImminentIn its most recent statement, the Federal Open Market Committee (FOMC) said it will continue to print $85.0 billion a month. With this money, it will buy $45.0 billion worth of long-term government debt and $40.0 billion worth of mortgage-backed securities (MBS) each month.

How long will it continue to do this? As the statement suggests,     “The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.” (Source: “FRB: Press Release–Federal Reserve issues FOMC statement–May 1, 2013,” Board of Governors of the Federal Reserve System web site, May 1, 2013.)

At the very core, what this essentially means is that there will be an increased supply of U.S. dollars. The Federal Reserve has printed a significant amount of money since the financial crisis to bring liquidity into the U.S. financial system. Its balance sheet has grown over $3.0 trillion, and as it continues to do the same for an unspecified amount of time, it will only increase. For example, even if the Federal Reserve stops printing (quantitative easing) at the end of 2013, its balance sheet will grow by $1.0 trillion regardless.

In the short run, the printing may work, the unemployment may decrease, and the inflation may stay tamed, but eventually, with what the Federal Reserve has accumulated over the years—the mortgage-backed securities and government bonds—it will have to sell them back into the bond market.

For investors in the bonds market, this may not be good news, because it poses a significant threat to their portfolio.

Think of it this way: when there are more sellers, or even one major seller, what happens to the price of a stock or commodity? The bond market operates on the same principle. As the Federal Reserve is a major buyer of bonds now, once it sells them, the downturn in the bond market can be severe.

Does this mean investors should start shorting the bonds? The answer to this question can be very controversial, but looking at the current state of the U.S. bond market, it is holding up strong.

With this said, it also doesn’t take a very long time for things to turn—and investors should be aware of this phenomenon.

If the bond market does start to decline, investors may want to look at exchange-traded funds (ETFs) like the ProShares Short 20+ Year Treasury (NYSEArca/TBF).

ProShares Short 20+ Year Treasury is an ETF that basically shorts or lets investors profit as the bonds with maturity over 20 years decline in value. It follows the Barclays U.S. 20+ Year Treasury Bond Index.

The rationale behind using this kind of ETF if the U.S. bond market declines is very simple. Currently, the Federal Reserve is accumulating long-term government bonds, and those bonds will be the ones going on sale when it tries to bring its balance sheet to normal.

As I have been continuously saying in these pages, investors need to adjust their portfolio as economic and market conditions change. If they follow this principle, they can grow their portfolio and reach their retirement goal in time.

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