Going Long on TBT

I've been watching Treasury yields for a while, looking for a sign that the bubble has burst. It looks to me like it might have. I'm certainly late to the party, as the Ultra Short Lehman 20yr+ ETF (TBT) is up considerably from its lows. However, I think it has far to go up, and the downside risk appears limited. This doesn't mean that it won't reverse course, but I think over the longer term (despite my misgivings about leveraged ETFs), it will do very well.

click to enlarge

First some numbers.

The current US public debt outstanding is just over $10.7 trillion.

As of November 2008, major foreign holders of Treasury securities own around $3.0859 trillion in US government debt. The top five are:

• China, $681.9 billion
• Japan, $577.1 billion
• UK, $360 billion
• Caribean Banking Centers (Bahamas, Bermuda, Cayman Islands, Netherlands Antilles and Panama), $220.8 billion
• Oil Exporters (Ecuador, Venezuela, Indonesia, Bahrain, Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, the United Arab Emirates, Algeria, Gabon, Libya, and Nigeria), $198 billion.

The principal reason that these foreign holders have been able to buy so many US bonds was the virtuous circle created by US consumers buying foreign goods and raw materials and shipping US dollars overseas, the proceeds of which were used to buy US bonds (and mortgages, etc). We bought their junk and oil, and they bought our debt. As everyone by now knows, the circle appears to be breaking, perhaps turning into a downward (death) spiral. Despite government calls for people to borrow and spend, consumers are actually starting to save.

The Japanese economy is facing a severe decline. It is expected to contract 2.5% in 2009, according to the IMF. A former Bank of Japan official is more pessimistic, expecting a decline of at least 3.8%. This will be on top of the 10% or more annualized decline in GDP in the final months of 2008 (expected, figures not available yet--the average estimate is for an annualized late 2008 GDP drop of 11.5%). Add to this political turmoil. Japan will probably be a less willing/able bond buyer. It has already reduced its US bond holdings ($582 billion in October 2008).

The United Kingdom's GDP fell 1.5% (a downward revision is expected) in the fourth quarter of 2008. The expectation for this year is a drop of 3%. With the pound falling and some currency experts calling for parity with the dollar, the UK probably won't be able to buy as many US bonds.

China, the world's 3rd largest economy (sorry Germany), is also facing problems. Its GDP is expected to grow at 7% in 2009. This is terrible for a country that requires 15 million new jobs annually just to keep up with population growth. China has already complained about the low bond yields, and has been angered by Geithner's currency manipulation comments. It's now likelier that China will start selling its US bond holdings instead of buying more.

Oil prices have come down a long way, leaving bond buyers like Saudi Arabia with far less cash to spend. Faced with a worldwide economic decline, other major bond buyers will also have less money to invest.

The US bond buying activities of the top foreign bond purchasers, then, should be curbed. With less buying interest from a major portion of the market, it seems that Treasury yields will have to go up. Add to this increasing supply.

According to Bloomberg:

The government will need to auction $493 billion in debt this quarter, 34 percent more than initially projected, the Treasury said on Feb. 2. It will probably borrow as much as $2.5 trillion during the fiscal year ending Sept. 30, compared with $892 billion in notes and bonds it sold the prior 12 months, according to primary dealer Goldman Sachs Group Inc.

Who is going to buy all this debt? As we saw, the major foreign holders may not be as willing or able. Other market participants will, sooner rather than later, demand higher yields before they start buying. While yields are up from their troughs, they are still very high historically. Barring another panic like we had in December, rates should not fall very much, if they do at all. (It's certainly possible that 30 year yields can fall to 0% in a super panic, but it is far more likely that they will continue rising. Also, if something like a 0% yield on the 30 year happens, we are royally screwed.)

The buyer of last resort is the Fed (which Marc Faber says follows the "Zimbabwe School" of economic thought). As they print money, they can buy as much debt as they want. If the bond market balks, the Fed will try to pick up the slack. The Central Bank can win a few early battles, but the market will win the war, as it always does. The more the Fed prints, the sooner the dollar's demise. If the Fed has to step in because other buyers are unwilling, those buyers will not be any more willing when the number of dollars increases. Interest rates will have to rise.

If/when interest rates rise, the economy will stagnate further. Consumers will spend less on foreign goods, which will leave less money for foreign bond purchases. Less bond demand (and ever more supply) will make rates go up even higher. We will eventually have inflation, as the Fed prints more money--more upward pressure on interest rates.

We can have inflation even if the economy continues to struggle. The Consumer Price Index was just under an annual rate of 15% in the late 1970s. They called it stagflation. The 30 year Treasury yield, which was around 8% at the end of the 1970s spiked to over 15% in 1981. It's hard to see why something similar will not repeat again.

The 30 year Treasury yield, at the time of writing, was at 3.683%. Let's say it goes back to 4.5% (the 52 week high is 4.813%) in the next few months. That's a loss of around 18.5% for the 30 year Treasury price. As TBT is twice the inverse, we can expect a gain of around 37% or more (as long as there isn't too much volatility). Over the longer term, if the US continues its massive borrowing, which it probably will, the yield can go a lot higher.

Note that if yields fall, the TBT will fall twice as much. Should the fall be significant, the expectation of a 37%+ gain if the 30 year yield is at 4.5% will have to be reduced. Example: the 30 year Treasury yield falls 10%, and then rises 11%. It's back to where it started. In this scenario, TBT will fall around 20% and then will rise around 22%. It won't be back where it started. It will be down 2.6%.

I'm going long TBT. If it falls (which it might), I'll buy some more. One major caveat here is that this trade seems like such a no brainer that it's bound to go wrong somehow. Easy money is always the hardest, as they say. If you're following me into TBT (hopefully you're already in it in from the low 40s or mid 30s), don't put everything into it. And please do your own research.

Other ways to play this, as mentioned before at the last market peak, are to short the long 20 yr+ Treasury ETF (TLT), buy puts or sell calls on TLT, or buy calls or sell puts on TBT.

Another way is to sell puts or buy calls on the 30 year Treasury index. These are cash settled. If you are long the option at expiration and it is in the money, you are paid the difference between the yield and the strike price. If you are short an In The Money option at expiration, you pay the difference between the yield and the strike price. If you are long an Out Of The Money option at expiration, you lose your premium. If you are short an Out Of The Money option at expiration, you get to keep your premium. If the strike prices are puzzling in the Yahoo! link, multiply the yield by 10 (e.g., 3.683% = 36.83).

If you are long Treasury bonds, think about using some of these to hedge yourself.

And of course, if you think Treasury yields are going down, do the opposite--short TBT, go long TLT, etc.

More information is always better than less. Click here for analysis on any stock, commodity, currency, or ETF.

Disclosure: I hold no positions in the above mentioned securities, but am planning to go long TBT.

Comments

[mr freddo:]

Thanks for the article on TBT. I have been using it with some success. I agree that it is a "no brainer" trade, thus dangerous. The biggest question mark in the short term is the Fed intervention which will no doubt come soon and may cause a short term reversal.

Feb 09 07:13 AM

[arlin:]

good article,im long TBT but also missed the buy at the island reversal around 37.63.that said adding on pb is worth serious consideration

Feb 09 08:26 AM

[ali khan_:]

typo above where you say: Other market participants will, sooner rather than later, demand higher yields before they start buying. While yields are up from their troughs, they are still very high historically.

You mean "very low historically"

Feb 09 09:21 AM

[Market Folly:]

nice write-up. just want to emphasize that using TBT is recommended for trades only, not longer term short positions. because, over time, the leveraged ETFs have issues tracking their underlying indexes since they reset on a daily basis.

a trade on treasuries though, TBT is your go-to vehicle. longer term short would be better with shorting TLT or buying puts on TLT. shorting TLT carries the problem of having to pay the dividend and buying puts on TLT is problematic because the puts are jacked up with premium since so many have flocked to this long-term bet recently.

we laid out our rationale behind a longer-term short of treasuries play here: www.marketfolly.com/20...

Feb 09 10:10 AM

[HaavBline:]

Excellent points about the problems of shorting Treasurys for long term. I had TBT too early and still had a loss despite recent upswing. Though I am confident about Treasury yields going up in long term, I can not be sure TBT will be able to track track faithfully long term. I have short IEF, but don;t like the need to pay someone dividends every month.

Try to check out your link, but only got "Blog not found". Please post you link again.

On Feb 09 10:10 AM Market Folly wrote:

> nice write-up. just want to emphasize that using TBT is recommended
> for trades only, not longer term short positions. because, over time,
> the leveraged ETFs have issues tracking their underlying indexes
> since they reset on a daily basis.
>
> a trade on treasuries though, TBT is your go-to vehicle. longer term
> short would be better with shorting TLT or buying puts on TLT. shorting
> TLT carries the problem of having to pay the dividend and buying
> puts on TLT is problematic because the puts are jacked up with premium
> since so many have flocked to this long-term bet recently.
>
> we laid out our rationale behind a longer-term short of treasuries
> play here: www.marketfolly.com/20...

Feb 09 10:35 AM

[kelm:]

TBT will not track at 2X the move over an extended period. Having said that I am long TBT and have been for awhile (long PST as well which is the 7-10 year) and both positions are doing very well. I bought into PST when it was near it's lows and when the volatility was low as well. What you will see I think is that if rates are say 3.7 today on the 30 year and TBT trades at X, then rates rise to say 4% and then come back to 3.7% a few days later, TBT will not trade exactly at X when it again comes back to the 3.7 level. There is a slippage due to the re-balancing that occurs each day. That is also why you see the after hours moves everyday.

Try buying in on dips.

I discuss the likely consequences of Fed intervention on my site.

And some trades are obvious

Feb 09 10:56 AM

[wmh:]

I bought TBT in the hi 30s and sold half at 46. I would have sold or held all, but it is unclear to me how this fund will behave when the Fed starts purchasing treasury bonds. If TBT tanks, I will sell and wait for a re-entry. If the opposite, I will add on and ride it up.

Feb 09 11:11 AM

[henarl:]

Excellent analysis on the pronosis for Treasuries and TBT.

I went long TBT in mid December at $36.76 so I'm looking good so far and if it goes above $50 I will take my profit. I don't think buying now in the high forties is adviseable because of the Fed but if they do cause it to come back down to below $40, I will increase my position.

Feb 09 11:41 AM

[Larry House:]

There are a lot of ideas that look good "over the longer term," however long that is. TBT is a very time-sensitive vehicle unless you have a cast iron stomach.

Feb 09 05:00 PM

[Nathaniel C:]

Everyone is worried about the Fed purcahsing Treasuries and how that will impact TBT. The Fed will have a hard time controlling long term rates. Look at mortgage rates. The Fed is currently buying 30 yr mortgages but rates are going up. The Fed can not beat the market over the long term.

Disclosure: Long TBT

Feb 09 07:25 PM

[dieuwer:]

If the crowd is running into one direction (long TBT), it does not automatically mean that they are wrong and you should go the opposite way.
A tiger might chase the crowd and thus it would be a stupid move for you to act oppositely :)

I guess I just want to say the "contrarianism" is not "automatism"...

Feb 09 09:20 PM

[Mad Hedge F...:]

If you believe that imminent and massive Treasury issuance is going to pop the Treasury bond bubble, and that Obama’s reflationary policies are long term inflationary, you have to be looking at Treasury Inflation Protected Securities. TIPS offer investors a US government guaranteed protection against future price hikes by raising the principal in line with the inflation rate. A 3% coupon TIPS facing a 10% inflation rate automatically boosts the face value of your bond from an issue price of 100 to 110, giving you a total return of 13%. You can buy these directly from the US Treasury, or buy the iShares Lehman TIPS Bond Fund (TIP). The best time to buy flood insurance is at the end of a long drought.

Feb 21 09:26 AM