As a follow up to my last post it is interesting to add some comments on operation twist which is likely the second major reason why, after fear and safe haven buying, that treasury yields have been recently falling.
Operation twist can only work in my view if the government targets the yield and not the size like they did in QE2 by buying 600 billions, which did not work. But to target the yield by lets say, fixing a goal to reach a 20 or 30 year treasury yield of 2.5% they have to finance the purchases by either printing money or like they say by selling short term bonds. Printing money would not work since it generates inflationary pressures so you can discard that one. Selling short term bonds like Bills or T-notes has a limit since they cannot sell more then what they have and has the problem that it leaves the FED overexposed to long term treasuries that are very sensible to interest rates and inflation causing a big fall in the face value of their balance sheet if they increase just a bit.
The fundamental problem is that they have a limited amount of short term bonds to sell, so targeting the yield and keeping it low for a long time would exhaust their resources and overweight their balance sheet to long term bonds (dangerous). The markets could deduce that the government cannot keep on selling more short term treasuries and that they would eventually have to print more money, which could again generate inflation pressures. And even if they do have the power to keep the long term yield low for some time, they have no power to control the international price of commodities and oil, which is a wildcard that can also generate inflation and force the interest rates to go up making the operation twist a failure since it is very dangerous to keep low interest rates simultaneously with inflation. So in my view the fed has limited powers against this, at most they have temporary powers and consequences like runaway inflation could come back with strength. So it’s not a good plan to start with, dangerous and not effective for long if they do it. It is also not very wise for the FED to buy long term treasuries as expensive as they are because they run the risk of losing a lot of the face value with the slightest increase in inflation severely impairing the FED’s balance sheet. Those treasuries could lose 20-30% of their face value if just a bit of inflation comes, or even more normal to high inflation comes . I do not think the markets or the FED is comfortable with that possibility.
I think its beyond the government power to control inflation and interest rates. They can just partially and for a short period of time control interest rates by buying treasuries but the amount of money needed to do that for a long period would be so big that the inflationary pressures would pop up on the long run. Therefore I do not think they can keep artificially low interest rates, the more they do the more they create a bubble that can pop and deflate with violence, that is precisely why I think a short on treasuries is interesting. The bubble did not disappear it just passed from private to public hands and seems to be specifically in treasuries now. As I see, after a certain limit, the more the government interferes with the markets the biggest the problem.
Nothing is certain, stocks can go to 0 on bankruptcy. You might decide to stay cash but cash can lose 50% of its buying power (or more) with a few years of inflation. You might decide to go long on bonds but they can lose its value, due to inflation or credit issues, gold can fall or go up, anything and everything has a risk. Whatever action or inaction you take is risky, as long as you are more often right in your analysis and on your estimations of the risk reward odds you should do OK, also as long as you don’t put all your eggs in one basket and you have the right character to avoid falling trap to your emotions and you keep them completely out of your investment decisions.
I’m basically sure that given the huge amount of debt and printing of dollars a 3% yield on 30 years treasury bonds is unsustainable on the long term so I act on that based on a specific and personal risk reward scenario assessment, and committing a percentage of my funds based on that, of course the possibility of a 20 year recession exists, but I think its very low, therefore the risk of not acting could make me lose much more if I decide to stay fully on cash due to a highly likely different scenario.
You can always buy a cheap TLT call options strike 150 to hedge against the unexpected black swan or extremely unlikely of TLT doubling. But note that the black swan could also be on the other side (big inflation) meaning that you would be better of in that scenario by shorting treasuries or buying cheap puts (a la Seth Klarman). Note that treasuries to double 1.5% yield on 30 year treasury bonds would be needed which has never happened historically, but for treasuries to fall substantially just a 5% yield is necessary, which is under the historical average.
To profit from a treasuries short you can scale the sales and do not forget to leave a lot of cash on the sidelines to avoid margin problems, to short more if it keeps on going up and to diversify with several stocks if the opportunity arises since if treasury yields do really fall stocks will more likely become much cheaper. In that scenario one good thing is to have housing construction stocks, since if yields temporarily stay low mortgage rates will be low and can cause a massive amount of refinancing or help potential new buyers to profit from the record low rates to buy a house. So any temporary paper loss on treasuries could be mitigated by an increase in housing related companies. The latter is basically my strategy.