Shorting the Long Bond: The Obama Solution Meets China

Oct.31.08 | About: ProShares UltraShort (TBT)

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