US Treasurys Selloff Picks Up, Bursting 'Bubble'

The Treasury bond "bubble" looks like it's leaking air.

Over the last three weeks, investors have been selling U.S. Treasury bonds heavily, giving the 30-year Treasury bond's yield this week its biggest weekly jump since 2001, shortly after the Sept. 11 attacks on the United States.

The sudden rise in lending rates complicates the U.S. push to lower mortgage rates and other consumer borrowing costs and kick-start the fragile American economy.

"Treasury bonds have sold off as markets have started to digest the rapidly growing volume of future government issuance," said Mohamed El-Erian, chief executive of bond giant Pacific Investment Management Co, or Pimco.

Treasurys performed spectacularly in 2008, returning more than 25 percent in long-maturing bonds, as investors piled into the securities when it became obvious the economy was heading off a cliff.

In fact, yields on long-maturing bonds were trading below 3 percent and only 1-2 basis points on three-month T-bills, the lowest in decades, in December.

The proximate cause for the selling in Treasurys stems from expectations that the government will need to borrow about $2 trillion of debt this year to finance its rescue packages for the battered banking sector. Already, outstanding Treasury debt stood at $5.5 trillion at the end of September.

With this in mind, investors are fleeing Treasurys. In fact, while the Dow Jones industrial average is down 7.5 percent so far this year, the 30-year Treasury bond is down even more at 10 percent. This is contrary to the usual dynamic, where Treasurys move in the opposite direction of stocks.

There are numerous roadblocks to lower yields ahead.

Timothy Geithner, who is expected to be confirmed soon as U.S. Treasury secretary, said on Thursday that President Barack Obama believed that China was "manipulating" its currency.

Following that statement, prices of Treasurys fell, reflecting worry among investors that China—the largest foreign holder of Treasurys—might be less willing to buy them if the new administration pushed the Chinese to further revalue their currency.

Furthermore, investors are also finding that there is more value to be had elsewhere, including high-quality corporate bonds.

"Treasurys are in their own unique dream world, trading at 2.60 percent for a 10-year Treasury note—and that is supposed to be a good investment, assuming zero inflation over that time?" said Jack Ablin, chief investment officer of Harris Private Bank in Chicago.

"I would rather own high-quality corporate bonds because they are money good. You will pick up double or triple the rate of a Treasury," he said.

Windfall in Bet Against Bonds

Pimco's El-Erian said it matters a great deal for weakened consumers and homeowners how the overall level of borrowing costs evolve against the backdrop of rising Treasury yields.

He said that if Treasury rates continue to rise, this would push up the cost of borrowing because mortgage and other rates are tied to Treasury yields.

"If that happens, markets will again ask whether the Fed is likely to expand its purchasing program to include Treasury bonds," thus limiting the rise of rates, El-Erian said.

However, some investors have wasted no time betting on rising government yields.

Doug Kass, president of Seabreeze Partners Management, has been shorting the government bond market, betting on a fall in prices and thus a rise in yields, since December.

Kass has been shorting the iShares Lehman 20+Year Treasury Index and it is paying off.

The exchange-traded fund is having its worst week ever on a percentage basis—down 5.8 percent. "There is huge price exposure in Treasurys and the longer you go out into the Treasury curve, the riskier you are getting," Kass told Reuters in December. He is still short the TLT fund.

What's more, shares of the ProShares UltraShort 20+ Year Treasury, an exchange-traded fund that gains when long-term Treasury bonds fall, is having its best week ever too, up 11.6 percent this week.

The ETF offers leverage, which magnifies returns when long-term bonds drop as they have.

On Friday, benchmark 10-year note yields, which move inversely to prices, closed at 2.61 percent. It was only one week ago that these yields were trading at 2.32 percent.

For its part, the 30-year Treasury bond closed Friday at 3.31 percent, up more than 40 basis points on the week.

"You can see that it hasn't been a good trade to stay in Treasurys," Tom Sowanick, chief investment officer at Clearbrook Financial in Princeton, New Jersey, said.

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