Should traders and investors short the US Treasury market? The bearish case is straightforward.

The budget deficit assures massive supply of government debt for years. Foreigners are having second thoughts about financing the deficit, highlighted by recent reports that China was selling some of its Treasuries. The crisis in Greece and elsewhere emphasises the risks of buying bonds from heavily indebted countries. Finally, the expansion of the Fed balance sheet through a variety of lending and asset purchase programmes threatens both the central bank's credibility and its inflation performance. Higher inflation would surely push long term yields much higher. Indeed, a month ago a prominent author and hedge fund manager suggested that "every single human being" should be short Treasuries.

Maybe so. Certainly over the long run the US must rediscover fiscal prudence and reduce its deficits or face a costly rise in borrowing costs. However over the medium term - say the next several quarters, a reasonable investment horizon - there are reasons to expect the Treasury market to hold its own, and perhaps even surprise with lower yields.

The deficit is high at about $1,500bn, roughly 11 per cent of GDP, similar to 2009. That 2010 deficit forecast has been fairly consistent for a year now. In other words, current prices - and the steep yield curve - reflect this level of supply. With the economy stabilising, receipts should also stabilise soon. In any case, the link between the absolute size of deficits and yields is inconclusive. Japan has run huge deficits for 20 years yet with the lowest yields worldwide.

But Japan finances itself from internal savings, while the US relies on foreigners. Aren't those foreigners getting edgy? Last month the Treasury reported its monthly tally of Treasury holders. While foreigners as a group were adding to their Treasury holdings, the Chinese were apparent sellers. Was this the canary in the coal mine? China's holdings reportedly declined from $800bn at the peak to $755bn at year end. This story received significant attention but, barely noticed, were subsequent revisions to that data series. These revisions showed that foreigners, in aggregate, were even larger buyers in 2009 than initially reported. Most notably, China's holdings were revised higher - significantly - with the latest estimate being that it holds $894bn rather than the earlier estimate of $755bn.

David Fuller's view Yi Gang, head of China's State Administration of Foreign Exchange, the man who temporarily roiled the gold market today by saying that bullion is "not a great investment" with a 30-year horizon, also reaffirmed his commitment to US Treasuries with this remark reported by Barron's: "The U.S. Treasury market is the world's largest government bond market. Our foreign exchange reserves are huge, so you can imagine that the U.S. Treasury market is an important one to us."


Yi Gang is right about gold, at least for China. If the PRC suddenly attempted to double its foreign exchange reserves in bullion, which currently amount to only 1,054 tonnes or 1.5% of China's official foreign exchange reserves, the price would immediately soar. Gold is a small market with most positions tightly held. China does not need to buy gold, which unlike copper would be of no strategic industrial advantage to the country. Nevertheless I think China will gradually increase its bullion reserves but as the world's largest producer of gold it can choose the timing.

Meanwhile, US Treasuries do offer China a strategic advantage because they help to keep its largest export market afloat. Since re-pegging its currency to the USD in July 2008, China lost nothing by holding US Treasuries but it has gained stability and diplomatic advantage. The US government dare not be too confrontational with China over trade, forex matters or anything else because it cannot afford to rile one of its two biggest creditor nations.

What about US Treasury bonds as an asset class for the rest of us?

I remain a long-term bear of US Treasuries for all the reasons mentioned by Dino Kos above. It seems self-evident that US 10-Year Treasury yields will revert to more normal levels of 5% to 6%, sooner or later. In the event of serious inflationary problems resulting from spiralling debt and money printing, they could even soar to levels not seen since the early 1980s.

However, I remain an agnostic on timing. Dino Kos' arguments for yields remaining low for an indefinite period are equally convincing and this uncertainty is reflected by the ranging price action. If he is right, a short-and-wait policy would be extremely expensive due to the yield. So I will continue to watch, perhaps being tempted if rangebound 10-year yields retest their lower boundary near 3.15% and hold, or when they eventually maintain a break above 4%.

Meanwhile, the longer they remain rangebound near current levels, signalling neither a Japan-style deflationary slump or growing inflationary pressures, the better it will be for the global equity bull market