The Trouble With Treasuries This Summer

The Long-Term U.S. Treasury market has provided an ideal way to hedge against the stock market. Since the beginning of the financial crisis, we have seen U.S. Treasury prices rise and yields move lower. And when the stock market has entered into periods of sharp correction, the U.S. Treasury market has soared. But while holding Long-Term U.S. Treasuries has been a rewarding position over the last several years, it faces some challenges in its role as a stock market hedge as we head into the summer and toward the end of Operation Twist in June.

A key challenge for Long-Term U.S. Treasuries at this stage is a result of the latest Fed stimulus program. When the Fed carried out its previous quantitative easing (QE) stimulus programs in QE1 from March 2009 to March 2010 and QE2 from November 2010 to June 2011, the stated intention was to help keep interest rates low. But the net impact of these programs was to cause U.S. Treasury yields to steadily rise, as investors were encouraged to sell their medium-term to long-term dated bonds and migrate back toward risk assets such as stocks. It was only when the Fed ended these stimulus programs that the U.S. Treasury market would actually rally and yields returned back lower.

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But with the launch of the Fed's latest stimulus program in Operation Twist starting in October 2011, it appears that the Fed had finally figured out the way to continue to provide support to risk assets while at the same time keeping bond yields low. This has been positive for the U.S. Treasury market in the months since. After the U.S. Treasury market surged sharply higher during the post QE2 period from July to September 2011, the Treasury market has been able to hold on to these gains this time around through April 2012.

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While this has been positive for those including myself that have continued to hold U.S. Treasuries over the past few months, it presents a challenge going forward. What made Long-Term U.S. Treasuries an attractive holding heading into a period without Fed stimulus was the fact that they had been sold off along the way. Thus, the potential upside was more meaningful as investors clamored back into the safe haven protection of Treasuries once stimulus went away. But the fact that U.S. Treasuries never substantially corrected during Operation Twist suggests that the potential upside from Long-Term U.S. Treasuries is likely to be more muted this time around.

Therefore, the Long-Term U.S. Treasury (TLT) market continues to provide an attractive hedge against the stock market (SPY), but the effects of Operation Twist have muted the strength of this hedge. As a result, investors may need to act more tactically with their Long-Term U.S. Treasury positions in the coming months than they had in the past. Also, it is worthwhile to consider other asset classes to complement Long-Term U.S. Treasuries as a hedge to the stock market as we approach the end of Operation Twist this time around. Leading candidates in this regard include Gold (GLD) and the Japanese Yen (FXY).

Disclosure: I am long TLT, GLD, FXY.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.