Shorting the Long Bond: The Obama Solution Meets China

In the financial world of collapsing hedge funds and incredibly volatile markets, macro trends are the dominant influence driving investment gains or losses. Currently investors have more questions than answers: Has housing neared a bottom? How long will the US recession last? How much will the global slowdown impact commodities? Has the low been established in the US market?

Questions like these are quite valid and everyone, myself included, has an opinion regarding the answers. Truly, only time will reveal the answers and it’s a guessing game at best. This overwhelming uncertainty is evident by the volatility in the financial markets. Investors are scared and the result is wild swings in stocks, illiquidity in corporate bonds and irrational despair driving investment decisions. Concurrent to these gyrations in equities and corporate bonds is a flight to quality, hence the low yields on long treasury bonds in the US. This flight to quality is creating a classic contrarian play on the US long bond market.

Profitable macro investing means finding obvious trends that are not currently exploited in the markets.

Profitably investing on a macro level, as opposed to gambling, means finding monetary trends that are obvious but not currently exploited in the markets. It was obvious earlier this year that real estate was weak; SRS, a double short Real Estate ETF, made its big move this last week. It was obvious two years ago that China was going to spend ridiculous amounts of money to impress the world at the Olympics; PowerShares' PGJ, a China-centric ETF, had a huge move.

The questions posed earlier have no obvious answer at this time, resulting in the confusion in the markets today. My advice: ignore those questions and focus instead on what is obvious for the future and how you can profit from it. What is coming to our future that strikes me as inevitable? Two things seem quite clear to me: Barack Obama will be our next president and that our economic slowdown is impacting trade with China. What do these two disparate events have in common? The death of the US treasury market.

The Obama solution meets China.

Having witnessed the Presidential debates, two thoughts occurred to me. First, Barack Obama is a tremendous leader and his ability to energize the youth will lead to a landslide victory in the election. That’s not a bad thing. Secondly, however, I noticed his answer to every question sounded true on one key theme: Obama’s solution to every problem is to increase spending.

In case you hadn’t heard, the US is already neck deep in debt. Spending on Iraq was eating up our budget long before the current financial crisis came along. The bailout packages, amazingly enough, have dwarfed that spending to the point that it’s almost irrelevant. Congress has no moral regard for the long term economic viability of our country or the US Dollar. The bailout acutely exemplifies the problems with our government now facing the American taxpayer:  to pass the bailout package, Congress added in $150B in pork!

Well, if you think spending is bad now, wait until next year. A landslide Obama victory will give him the mandate necessary to increase spending in ways unimagined by the incredibly generous George W. Bush. Financing this spending will be quite onerous and, with a deep recession taking hold here, tax increases won’t be appropriate nor generate enough money to begin to finance our federal deficit. It’s up to the Treasury to sell bonds or print cash. This brings China into the mix.

Increase spending, decreased lending and a recipe for disaster.

China has been propping up the US Dollar versus its currency, the undervalued Yuan, for years. The economic growth in China is directly tied to this currency disparity and the continual support of the US consumer. Unfortunately for China, the US consumer seems to have hit the proverbial brick wall and will be retrenching for years to come. This will create an uncomfortable time for China as its export related industries will suffer significantly, causing turmoil in the domestic economy. All is not lost, however, as the deep financial reserves accumulated by China will allow them to increase domestic spending on infrastructure investments and continue focusing on increasing their domestic economy, led by the increasing middle class.

Sadly, this refocusing of China’s financial resources does come at a cost: China will no longer be able to support the US Dollar. This is not a good thing for Barack Obama’s plans. For, while China was artificially depressing its currency, it became the largest buyer of US Treasuries. Thus, while we stand on the verge of a huge increase in US Treasury offerings, the largest buyer has left the trading room. A recipe for disaster? You bet.

The outlook for interest rates on the long end of the market is abysmal. Future rate cuts here, they’re coming, will only lead to increased concerns over US spending and possible inflation. A weak dollar causes pain for foreign governments that hold US treasuries. Increased domestic spending by foreign governments along with concerns over the future valuation of their US Treasury holdings, could lead to selling of these securities. Not only has the largest buyer lost firepower, the US Treasury could be competing as a seller of securities when it goes to raise money.

To profit on Treasury Weakness, buy TBT.

TBT, a double short ETF based on the Lehman 20 year treasury, is my play on the eventual outcome of the global forces at work here. I am a firm believer that Washington will never swallow the bitter pill of lower spending. Instead, expect a mortgaging of our future as they print money to bail out those who spent what they didn’t have. I’m short the US Long Bond and will remain so until I see anything resembling fiscal prudence coming from Washington.

My guess, we’re on our way to 7% on the 30 year bond and I only hope we stop there. When does the selloff begin? I believe it started two weeks ago when liquidity returned to the credit markets. The bailout package marks the bottom of the flight to quality and the beginning of the big spend. Obama will accelerate that spending. The only question is how long will China continue to foot the bill?

Disclosure: Author owns TBT

Comments

[John Lounsbury:]

The hope is that Obama is as intelligent as he seems. In the first debate he said that the implementation schedule for his proposals could be delayed by economic conditions. He has not said that since. I hope the reason it has not been repeated is a campaign ploy, not a a change of intent. McCain has done a very poor job of defining this (and many other issues) in his disappointing campaign. Finally, with Paul Volker at the center of Obama's economic team, there is hope that the new president will support fiscal responsibilty.

Of course, McCain may pull the upset. Then the outlook will change? I can't tell from either the campaign or McCain's voting record. Will he govern with the policies he supported since approximately 2002 or go back to more distant historical positions?

2008 Oct 31 09:15 AM

[SW Richmond:]

Excellent. Maybe I think so because I agree, and have been buying TBT for the past two months. Nothing could be more obvious than the unimaginable pressure on Treasuries. If they stay short, interest rate increases could trigger a debt trap so fast that nothing could save them. They must go long, and all that supply is gonna kill prices.

Great line, succinct:
"Thus, while we stand on the verge of a huge increase in US Treasury offerings, the largest buyer has left the trading room."

Bloomberg carried a recent article which is captioned: "``This year's financing needs will be unprecedented,'' said Anthony Ryan, the Treasury's acting undersecretary for domestic finance, at a Securities Industry and Financial Markets Association conference in New York, where he was a last-minute substitute for Treasury Secretary Henry Paulson."

Unprecedented indeed.

I have a thread on one of the blogs I follow titled: "Tracking the US Treasury Bond Apocalypse." It (along with my early retirement?) is practically carved in stone.

One Q: I have seen allegations that there are techniques that the Fed and Treasury can use to sanitize long rates using some BS circular accounting methods (in other words, lying). As we have seen with this entire unfolding catastrophe, you can only lie about math for just so long. Any thoughts?

2008 Oct 31 09:22 AM

[Zee4Money:]

You're concerns are right on target. However, one significant source of potential reduced spend must come from DoD. We are currently spending in excess of $750B a year on defense. In 2000 the DoD budget was $250B. A change in priorities for defense could be a big source of money. However, the earliest any significant changes will occure to spending will be FY10-FY12. Watch the future years budget to see if there is any hope for a return to fiscal responsibility, otherwise you are correct and long term rates are headed much higher. We simply can't grow fast enough to generate the revenue.

2008 Oct 31 10:11 AM

[bearfund:]

Agree completely, this is a great macro no-brainer. 7% is very tame; 10% is a reasonable target for conservative traders. My experience forecasting previous macro moves has been that even the most breathtaking predictions usually fall well short of eventual reality; when macro pressures let go, they really let go. My gut feeling is that we could in time see Treasury yields at levels we would expect for emerging market sovereigns in crisis.

2008 Oct 31 10:25 AM

[HoustonKing:]

I think you are full of it. Obama will save us from this because people will respect us more from the change and hope that he is bringing. Doom and gloom is all you are. You are a typical liberal San Fran loser.

2008 Oct 31 11:45 AM

[Alan Young:]

I agree with your central thesis, and your article makes good points about China's role. I have also been accumulating TBT for a couple of months because, as you say, the outcome is obvious.

However, I disagree with your focus on the presidential election. If Obama ends the tax breaks for the rich and stops pouring money into the military contracting toilet, we will be in a better fiscal position than with Bush or McCain. But it won't be enough, so that doesn't matter.

2008 Oct 31 12:04 PM

[Duude:]

I would go a step further by emphasizing that labor is going to experience a resurgence in power in the U.S. They are core to Obama's support. They also are the least knowledgeable of the effects to the economy many of their trade barrier proposals would have if adopted. Obama has painted himself into a corner here. I fully expect at least some form of trade war will develop specifically with China. This will only embolden China to turn even more inward. They will only support the dollar as far as they need so as to unwind their own position slowly without hurting themselves in the process. Democrats will reach for their old reliable 'blame the Republicans' for their prior hold on power as we all experience the pain of a trade war.

2008 Oct 31 01:16 PM

[rdr4:]

1. Seems like China has the right to spend what they can afford on their Olympics, no one has come close to their presentation in my 59 years of Olympic viewing. They clearly did not need Steven Spielburg.
2. China has been signing trade agreements around the world during this century. China does not seem to be thinking of the US as the only game in town.
3. The political debates are paid for by large corporations, like patent medicine. The arrangement is that the producers get a huge tax write-off and the debaters get free air time. There are rules of engagement and limits on how far a participant can be pushed on any issue. I'm not convinced about any of what I hear.
4. I have severe doubts about Palin. One of the worse greenhouse gases that is affecting our environment is cow flatulence.

2008 Oct 31 01:40 PM

[Larry House:]

Thanks for a great insight. I think your reasoning, however, applies no matter who the next president is. I think we have passed the crest of reason and are on the sleigh ride of our lives until we wreck at the bottom.

2008 Oct 31 01:50 PM

[Mmarrkk:]

Love it! If Obama stops the "tax breaks" for the rich. You mean those guys who pay over 50% of the taxes in this country? Those guys who own businesses and create jobs? yeah, that's going to help. His focus on increasing corporate taxes is scary. Did someone tell him that businesses create growth, government does not. We have the 2nd highest corporate tax rate in the world...wonder where businesses will go to create jobs...here where we tax and berate a successful business or other countries that actually appreciate successful businesses and encourage them to come to their country and MAkE MONEY. To hear Obama speak, you'd think profit and success are evil. The bottom line is he is a Democrat and their solution is always a) spend more, b) tax the rich, c) tax the successful, d) tax business, and e) give all of it to those who don't want to do anything to help. I guess his MENTOR and PASTOR was just saying out loud what O thinks:..."God D*** America!". What a crock.

2008 Oct 31 04:11 PM

[buyitcheap:]

The "quality flights" that push the long bonds up will likely continue to provide good entry points on TBT and PST as well. Between that, and UDN, it's the easiest money in town.

2008 Nov 01 06:33 PM

[bearfund:]

buyitcheap, UDN? Why? The only reason to own euros or pounds instead of dollars is that there is a bit of yield to be had in those currencies, and you don't get that in UDN anyway. You've seen that other central bankers are now revving up their own presses in an effort to keep up with the Fed's debasement of the dollar. I find no compelling value in any fiat paper at these prices.

2008 Nov 01 07:26 PM

[Kunst:]

I like TBT, but there is another possible ending to this story.

In an honest world, the insatiable need to borrow to finance our out-of-control deficit spending would drive up interest rates. In an even more honest world, we would someday get to a true surplus (even Clinton didn't have that -- the total debt went up despite his "surpluses" because of the fraudulent accounting of Social Security payroll taxes) by the government spending LESS than it takes in in taxes. It think that last happened in the 1950's (Johnson faked one year and then there was Clinton's "almosts".) That's not going to happen.

We are a dishonest nation with a dishonest government (they go together -- we want government services, we just don't want to pay for them). The end result will be an effective default. We will print money to pay off our creditors, but both they and we will be poorer for it. Apparently there is a treasuries for dollars swap that can be done between the Treasury department and the Fed to carry this out, but it's the end result that matters. A whole lot of new dollars, existing debt largely wiped out by a much cheaper dollar.

In this case, interest rates might not rise as they should in an honest market. They should rise because of supply and demand, the need of the US government to borrow dollars to cover our deficit spending. If we create trillions of new dollars, we don't need to borrow. In fact, we can even pay off our existing debt.

Of course, future borrowing would no longer be in dollars. Oil would rise to astronomical levels for Americans, forcing a drastic reduction in imports, with obvious results for the US economy and standard of living.

The US is bankrupt. It just hasn't filed the court papers yet.

2008 Nov 02 01:46 AM

[Michael Pettis:]

Although I agree with some of your conclusions, I think you make two very common mistakes. The first is the assumption that China can use its foreign reserves to shore up domestic investment. It cannot. Reserves can only be used for spending abroad, and if China tried to convert reserves into RMB it would cause a massive surge in the value of the RMB that would destroy its export sector. Given the importance of the export sector to China, this will almost certainly not happen. The PBoC, by the way, has tried to point this out many times but most people continue to confuse foreign reserves with domestic wealth.

Second you say "Thus, while we stand on the verge of a huge increase in US Treasury offerings, the largest buyer has left the trading room." I am not sure how you came to that conclusion. As long as China runs, or wants to run, a trade surplus with the US (and August and September were the two highest surplus months in history), it has no choice but to buy US dollars directly or indirectly. If it stops, its trade surplus with the US disappears. Again, given the importance of its exports to the US, it is pretty unlikely that it will want to do so – on the contrary they are now doing everything they can to shore up exports. In fact while China's reserves continue to surge, there is some circumstantial evidence that they have increased the dollar share of total reserves.

2008 Nov 02 02:01 AM

[SW Richmond:]

Kunst,

I concur with your assessment in it's entirety. Default is default, whether real or "de facto". The end result for the US is the same, but for TBT it may be different. Not putting all eggs in one basket here, just spreading dollar shorts.

2008 Nov 02 12:23 PM

[Scarlett fr...:]

Dan, you obviously know our stuff ;).........See you at the MB Traders Expo.

......And I definitley agree!

2008 Nov 03 08:26 PM

[String:]

3.45% oops!

2008 Nov 21 04:29 PM