Shorting Treasuries: What's the Rationale? 11 comments
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Essentially, U.S. Treasuries are setting up to be a great short opportunity. Last week, I laid out a basic thesis for shorting treasuries. We may be early in this call, but present and future actions are sending us signals we simply cannot ignore. The presently increasing and future supply of treasuries is simply too large. As Martin Hutchinson over at Money Morning highlighted:
The U.S. Treasury Department announced Nov. 3 that it intended to borrow a record $550 billion in the fourth quarter. That represents a staggering $408 billion increase over Treasury's borrowing estimate from early August and includes $260 billion for the recapitalization of U.S. banks. Make no mistake about it: There will be enough U.S. Treasury bonds to choke on, as the government tries to finance this debt.
All signs point to this trend continuing. In the quarter prior, the government borrowed $530 billion. Now, with the recent news out that they will borrow an additional $550 billion, the question then becomes, when does it end? The current flooding of the market with treasuries is reason enough to get short them. However, with the impending tsunami of future government borrowing still to hit, it just makes the bet that much sweeter.
Inevitably $800 billion to $900 billion of additional money flowing from domestic investors into Treasury bonds will do three things:
- It will drive up interest rates on Treasury bonds.
- It will tend to crowd out other financings, making finance difficult to obtain for medium-sized and smaller companies and more expensive even for the behemoths.
- And finally, it will increase inflation, as the Fed is forced to expand money supply to give investors enough money to buy all the Treasuries.
So, we can see that the consequences of their actions definitely play right into our shorting thesis. The main point we're focused on here is the fact that interest rates on Treasury bonds will rise. When the yields increase, prices will drop, thus benefiting our short position. And, the case can easily be made that the longer-dated treasuries will suffer the most. After all, do you want to loan the government money for 20 years at a paltry interest rate? We didn't think so.
Warren Buffett was even out mentioning the under-performance of cash equivalents in his latest comments. He wrote:
Today people who hold cash equivalents feel comfortable. They shouldn't. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.
Now, although
The actions of the government not only lay out the premise for shorting treasuries, but also the U.S. Dollar. As inflationary pressures will weigh heavily on the Dollar in the future, eventually something has to give. The only problem here is that other forces are at work on the U.S. Dollar as the world continues to deleverage and hedge funds are forced to sell assets and continue to face redemptions. So, this play could ultimately take even longer to play out. We will address shorting the U.S. Dollar in a separate post further devoted to that rationale.
The main thing to take away here is that the government has demonstrated that they have and will continue to borrow money by the hundreds of billions. As yields on treasuries rise, prices will drop, especially on longer-dated treasuries. Now, the question becomes exactly how do we play this? Not everyone has access to shorting the 10 year and 20 year treasuries outright, so I am here to offer some other alternatives. As I laid out in my first post on shorting treasuries, there are a few vehicles in the stock market that one can turn to, such as tickers ProShares UltraShort Lehman 7-10 Year Treasury ETF (PST) and ProShares UltraShort Lehman 20+ Year Treasury ETF (TBT).
PST is the ETF for UltraShort the 7-10 year treasury. An UltraShort ETF seeks twice the inverse of the underlying security. So, buying PST gives you twice the inverse of the performance of the 7-10 year treasury (effectively a double short). Additionally, TBT is the ETF for UltraShort the 20+-year treasury. This ETF seeks twice the inverse performance of the 20+-year treasury (also a double short). So, those are two very easy ways for people to get short treasuries by buying those tickers in the stock market.
Additionally,
Disclosure: The author is long TBT.
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This article has 11 comments:
Huh? Higher demand for the bonds will drive rates down, not up. Also, money cannot be "flowing" from investors into bonds because it cannot flow out of anything else - in a zero-sum game, everyone dumping (say) stocks to buy bonds has to find a buyer for the stocks, and that buyer has to surrender cash or bonds to make the purchase. So, while prices can move relative to each other, and wealth transferred, there's no net flow due to investors actions.
The new issuance has to ultimately be supported by monetization - there's some "flow" for ya. Yet this need not be inflationary in the short run, since despite the monetization the overall money supply may still be contracting due to deleveraging. If the government prints up bales of money, hands it out to the banks at 0% interest, and the banks turn around and gobble up treasuries at 2-4% interest, all the while deleveraging their loan books, you could see the money supply contract even as the government drops cash into the system due to an inverse of the multiplier effect. Throw in a sharp decline in the velocity of money, and you can see a way forward that involves a kind of stagnation a la Japan.
I agree that at some point the dam will burst and the US government's massive expansion of debt will ultimately tank the long bond, but it's not clear when this is going to happen. IMHO, that's in the hands of foreign creditors, who may decide to pull the plug on our debt next month, or who may continue to play along as they have for the past decade.
# It will tend to crowd out other financings, making finance difficult to obtain for medium-sized and smaller companies and more expensive even for the behemoths.
# And finally, it will increase inflation, as the Fed is forced to expand money supply to give investors enough money to buy all the Treasuries.
We are first heading for a "command economy", and failing that - "state capitalism".
Shorting governments should be outlawed.
Deficits obviously generate a net increase in the demand for loan-funds; the larger the deficit, the greater the demand. That doesn't necessarily mean interest rates will be higher, the only other conclusion is that the deficits are keeping interest rates higher than they would be in the absence of the deficits.
While current deficits increase the demand for loan-funds, the expectation of higher rates of inflation, and larger deficits, decreases the present supply of loan-funds. Lenders, as a group, will not as a rule, lend long-term except at rates that will compensate for the expected rates of inflation. Thus, the deficit financing impacts on the supply side (as well as the demand side) will push interest rates up or retard their fall.
The more alarming aspect of the deficits is not the effect on interest rates but the effect of interest rates on the level of taxable income and the volume of taxes required to service a cumulative debit now exceeding $11T. Higher interest rates and higher taxes induce stagflation, thus eroding the tax base, and increasing the volume of future deficits.
The problem is not excess demand for bonds, but excess supply, and therefore demand for dollars. The article didn't word it well, but is right. Yes, the money has to come from somewhere else, but what happens is that the price of the something else (e.g., stocks) goes down if money flows away from it. This is one of the reasons stocks don't do well in a high-interest environment. And as flow5 points out, higher interest rates hurt businesses that need to borrow too. The problem is that all this new borrowing is going to be hard to manage without higher interest rates. Like anything else, if you have to sell a lot, you will probably need to drop the price (interest rates go the other way, so up).
I agree about the monetization of the new (and maybe old) debt. The Fed can effectively "buy" the bonds from Treasury in exchange for dollars it creates out of thin air. Yet another benefit of having your debts in your own currency. If our creditors give us grief, we can just write them big checks and tell them to get lost. Iceland didn't have that convenient option. This is a risk to the TBT approach, although I don't think monetization (the government buying its own bonds for electronic-printing-pr... cash) will happen until the crisis deepens.
Last I looked we were paying over $400 billion a year just in interest on the national debt, in a low-interest environment. Now toss $2-3 trillion of new borrowing together with higher interest rates, and we could be looking at a trillion dollars a year of interest payments. That's half the federal budget. At some point short of that, it just doesn't work
One assumption that is being made is the foreign governments will continue to purchase US treasuries at the same rate that they are currently doing. The first problem with that assumption is that the US will not be importing at the same rate that they have historically. That means that the funds available to purchase US treasuries will not be available at the same level that they were before. The second problem is the ever increasing amounts of money that the US must borrow. Even if the foreign governments were will to keep purchasing Treasuries at the same level, not going to happen, US deficit is exploding. IN the end interest rates will explode and inflation is the only way out of this mess since default is unthinkable.
A nation that loses its manufacturing industry is surely a nation in decline but the alternative is to become more competitive, that is, to work for less. Will the UAW and the corporate execs voluntarily take pay/benefit cuts - even to save their own jobs? The government can take the cost of health care off their backs but that requires borrowing even more. My best idea is to tax consumption instead of payrolls.
Can anyone help?