Short Treasuries? Never A Better Time

As traders try to figure out the finer points of the yield curve, and as the realization dawns that the Treasury will flood the market with debt paper in forthcoming weeks and months, the case for shorting treasuries is certainly compelling. The cogent arguments presented in this regard by Market Folly (postings on Seeking Alpha, November 6 and 13, 2008) make a persuasive case in this regard.

But if you need to buttress those arguments, simply take a look at (a) the nature of the recent Treasury auction activity (shallow interest, long tails), (b) the trends in yield spreads (2-year/3-year, 2-year/10-year) and, finally, (c) the amount of money the government requires to borrow ($1.5-2 trillion) to fund the never-ending stream of bailouts, stimulus packages and spending programmes following the January inauguration of Barrack Obama.

Allowing for some defensive action in the event of Fed rate cuts, the proposition supporting the establishment of short-treasury profiles via long positions in UltraShort ETFs (ProShares UltraShrt Lehman 7-10 Yr ETF (PST) and ProShares UltraShort Lehman 20+ Yr ETF (TBT)) is firmly grounded in government reaction (i.e. rescue schemes) to economic and corporate data, for the rest of this year and through 2009. Motley Fool has provided the facts, and anticipated facts, in the postings cited. But while Motley Fool cautions on the “early” nature of the call, this writer now recommends aggressive accumulation of long UltraShort positions each time market euphoria generates healthy pricing misalignments. (A posting by Trade Radar Operator, Nov 15, 2008, referencing UltraShort QQQQ ETF (QID), offers interesting technical information in relation to equities).

The reason for the aggressive recommendation, as distinct from an early call, is based on the belief (as alarming as it may sound at this juncture) that the yield curve has started to price in, expressly or implicitly, some element of US government risk. Professional arbitrage players have already started to redefine the risk-free rate concept, given that 5-year CDS spreads on securities issued by the US government have widened to 48-55 basis points since late last month. These spreads are only headed in one direction, i.e. the 60-80 bps range, as the socialization of banks, insurers and auto makers will lead to increasing uncertainty on the quality of America’s credit 3-5 years into the future.

This writer is not speaking to the real potential for a US government default; rather, this writer is calling into question the government’s medium-term and longer-term credit quality (rating) in conditions where the success (or failure) of the socialist agenda depends almost entirely on the shape of the domestic and global economies well into 2010, and possibly beyond. It should be pointed out that, the Lehman collapse caused CDS spreads for Greece rose to 95 bps (from 40 basis points); CDS spreads for Italy (80 bps), Ireland (80 bps), Portugal (75 bps) and Spain (70 bps) also doubled in the second half of September. For comparison purposes, at the other end of the sovereign default risk spectrum are Argentina and Ukraine (implied default probability 80% in both cases).

So those trading, or investing in, treasuries should not assume that governments bonds (even US government bonds) are immune to liquidity or risk spreads, particularly in a climate where the underlying, formative unknowns far outweigh the knowns. One of the guiding premises of the Motley Fool call is that the bailout-induced borrowings will inevitably drive up interest rates on treasuries bonds. Risings rates will allow for relatively broader accommodations for longer-dated credit-risk perceptions, mathematically speaking, more so if higher rates occur amidst unequivocal evidence that government intervention in business and industry has proven to be a disaster for private capital.

Disclosure: Author owns positions in TBT, QID

Comments

[igggy:]

Makes sense but it's also too obvious. Makes me wonder if the rest of the world will keep gobbling up US debt no matter what (given the current circumstances). Nonetheless, I am long TBT too.

2008 Nov 17 04:36 PM

[Pipo:]

jimrogers-investments..../

"Once Asian central banks cease buying US government bonds, all bets will be off. When will that be? I don't know, and I don't know why they keep doing it... I certainly wouldn't - I'm shorting US Treasury bonds," JIM ROGERS

2008 Nov 17 05:55 PM

[jahowle:]

An investor can take some of the risk out of being short by taking a spread trade with munis and treasuries. You could buy PZA which is a muni ETF with about the same duration as TBT. So you could be long TBT (which is a short position in the long Treasury) and long PZA. Keep in mind that TBT is a double short so you would need to buy twice as much of PZA on a dollar basis. Now you would be long munis and short Treasuries with a positive carry since there is not interest to pay on the TBT and PZA pays about a 4.50% tax exempt dividend. Then you sit back and wait for the spread (which is at levels far above anything I have seen) collapse.

2008 Nov 17 07:46 PM

[jahowle:]

In regards to the post I made on the PZA/TBT spread trade keep in mind the John Meynard Keynes quote ' The market can remain irrational longer that an investor can remain solvent'. I put this trade on some time ago and was under water in mid Oct as spreads widen out even further. Caveat Emptor.

2008 Nov 17 07:51 PM

[Leonard the...:]

To dtv999 - yea I don't like investments that are "obvious" because they make so much sense either.

I prefer investing in only things that make no sense what so ever or are much more "ifffy"

2008 Nov 19 08:18 PM

[JohnnyJunk:]

Is there an ETF that shorts long-term treasuries that isn't leveraged? Isn't holding leveraged ETFs not a great idea for the long or even intermediate term?

May 17 06:42 PM