Don't Short the Fed Yet

There has been lots of chatter about the recent drop in the 30 year bond price. The debate is focused on two points: “Is the Fed still in charge of monetary policy?” or “Is there really an deflationary scenario unfolding that justifies this currency debasing through debt?”.

For investors looking for low risk gains, this great theoretical debate provides ample opportunity to make a profit.

There is a lot of solid alarmist reasoning from a theoretical point of view like the overall amount of debt, the increased frequency of Treasury auctions, etc. If we were debating in my college Econ 101 class, the idea of massive stimulus financed by lots of long term debt with the current outstanding account deficit would be considered an instant recipe for disaster in a perfect system. Sure, there is an increasing risk that the US will hit a magical limit of borrowing and foreigners will flee and put their money under their mattress. But this is reality and the world does not operate according to models.

First of all, in the world of investment choices for sovereign nations, there are really very limited choices regarding where to put major currency. The Japanese economy is currently declining at a 13% annualized rate and heavily dependent on exports to suffering economies. The European banking system is still unraveling and considered to already be insolvent.

With this in mind, and a limited amount of canned beans, shotgun ammo, and gold bullion available to buy, the Treasury bond market will still see a thriving business.

The Chicken Littles love to tell stories about how the Chinese are crazy for buying 30 Year Treasury Bonds at 3.5% and will soon take their money home for domestic investment for higher returns. This logic is flawed for two reasons. 1) A purchase of Treasuries increases in return if a government believes that its currency could possibly devalue versus the USD in some point in the future. In such case, the USD denominated Treasuries provide a highest quality hedge against any internal stability risk and also against lagging relative performance for China versus the US economy. 2) Besides the Fed Discount rates, the Fed also has the ability to control rates by choosing where on the yield curve it issues debt, or “paint the tape” as it is called.

From Across the Curve, Feb 4, 2009

The Treasury did announce that they will auction $32 billion 3 year notes, $21 billion 10 year notes and $14 billion Long Bonds next week. That package is in line with street estimates.

What was not in line was the profile of the new 7 year note which will be auctioned at the end of this month. Most street analysts had anticipated that there would be a 7 year note and it would be issued quarterly. The Treasury opted for a monthly 7 year note. The private sector Treasury Borrowing Advisory Committee has recommended that the new note should be auctioned for $15 billion at its initial offering at the end of the month.

So although the amount of debt overall and amount of debt sold over the next few years may increase greatly, the notes sold at the shorter maturities will probably be the bulk of the issue, not the 30 year. Thus the Fed will be able to use the proportionately small amount of 30 year Treasuries to request higher bids for the debt.

This is a significant event, and a prudent market move by the Treasury. It is easy to see a sizable profit margin in selling 3-yr, 5-yr, or 7 yr debt when one views the medium term view to present scenarios of zero to even high single digit deflation. For the Chinese, buying up these medium term instruments provides a high degree of safety and a high yield for a negative interest rate environment.

As much as you may not like it, or if it breaks all of the old rules of investing that you have learned, in short term, the Treasury will be able to issue more debt to fund even larger government economic initiatives. Yet we cannot increase our deficits too much or we face a situation where we will debase our currency.

What is an investor to do to profit from this situation?

There are only really two acceptable outcomes on which to base trading positions:

1. The Fed is on the brink and foreigners will flee in the immediate future or
2. The Fed still has fighting power, even solid demand, and will have a linearly increasing chance of a day of reckoning in the unforeseeable future (foreseeable meaning a year or less in this chaotic environment).
   

In the case you are in the #2 camp, then like me, you need to go long TLT. Even with the new stimulus package and the plethora of financial stability programs du jour, the government will only have spent 40% of GDP. This is a comfortable deficit number considering the situation, according to economists like Paul Krugman and Mark Zandi.

Thus in the short term the Fed will make purchases and bring the 30 year down to make house prices affordable using 30 year fixed instruments. With all of this uncertainty long term, that is all you need to know. Sure, there will be TARP 2.0, 3.0 and probably 4.0. But this is speculation for the next Federal budget cycle, and can only be addressed through futures or long term options. It also should be noted that at each crisis point for the private banking system, investors flock to Treasury instruments for safety. Although probable again, crisis points cannot be predicted or used as an investment thesis. In the meantime, benefit from deflation pressures and the Fed effort to manipulate the long term rates and let the future worry about itself.

Full Disclosure: The author is short TLT $94 JUN 09 puts at $3.3, long TLT $91 JUN 09 puts at $2.25 and long TLT $105 SEPT 09 calls at $5.5.

(Each investment will be treated as 50% of the total position)

Comments

[K T Cat:]

You miss one major possibility. No matter how attractive they are, if there's no one with money to buy them, their price will have to go down. The list of buyers with enough cash remaining to buy a significant portion of what will be auctioned is shrinking daily.

Even the best investment in the world can go unclaimed if there isn't anyone to buy it.

Feb 17 08:44 AM

[Larry Livin...:]

Think about it this way...total supply will increase by around 30% this year...total demand from foreigners will have to go down by a minimum of 15% (think shrinking trade surpluses) this means that domestic investors or the fed will have to pick up the slack just to keep them where they are...the risk/reward ratio of shorting them is quite favorable...

Feb 17 10:59 AM

[David White:]

Good article. You have a point. However, you may have missed the fact that the Chinese are spending most of their money on internal development this year. They are betting on themselves. This seems likely to have a negative effect on US bond demand.

Feb 17 12:01 PM

[Jolly_Rancher:]

You miss one major factor: panic. Investors around the globe mostly in long term unstable economies who have earned trillions of dollars over the last decade will send much of it back to the US and probably park it in US debt. This will support the huge issuance of new debt.

Feb 17 12:20 PM

[Jay-Dawg, CDA:]

You write:

Even with the new stimulus package and the plethora of financial stability programs du jour, the government will only have spent 40% of GDP.

I'm sorry... ONLY 40% of GDP?! Only?!

I'll have to disagree with the article... I just don't think there is that much upside potential to owning treasuries. Rates are at historic lows, and pretty much the only thing that could lower them even more is monetizing the debt (printing money to buy back long term treasuries). If that happens I'm guessing you would be better off owning gold than treasuries... At least gold would protect you from the inflation that would result from such actions.

Jay

Feb 17 12:29 PM

[Archman Inv...:]

Treasuries and the US dollar continue to rise for one reason and one reason alone.

It is not about safety or "quality".

It is about "quantity"

Buyers of US debt / US dollars etc know this:
The US Treasury and Federal Reserve loathe and hate its own citizens. They know they have no accountability to anyone. They know they general public is beyond complacent and has taken the attitude that "some how", "some way", everything will manage to work itself out.

They are given free reign to debase the currency, pile on as much debt as they see fit, regardless of what god awful outcome there may be to this.

The rest of the world knows this. That is why treasuries and the dollar keep rising.

The US dollar, US treasuries at face value are truly awful investment instruments. However when you have a system where it has become "law" so to speak, to do anything, without any accountability, then of course others will flock to the products of that system.

I have no crystal ball, no idea where all this ends, however anyone with any sense of reason knows that at some point, reality will set in, and all this non-sense will reverse course.

Feb 17 01:04 PM

[Keepin it r...:]

Great analysis, however, you missed the elephant in the room. 90% of all countries are running at ever-growing deficits, the Fed needs to borrow 2 trillion in new money 2009, most of the states will need to borrow billions, most municipalities will need to borrow money, and the list goes on endlessly....If the world needs to borrow say 4-5 trillion in 2009....who is going to lend it? No matter how optimistic you are about treasuries being the safest investment...there simply will not be enough to go around...therefore the Fed will be forced to print the money (via quantitative easing) and the the dollar will lose value and rates will go up and the vicious cycle will go on and on until it breaks..

Feb 17 01:10 PM

[mkreisel:]

Lots of people only see the weakness of US, but fail to see its relative strength. If any of you ever bothers to look at balance sheets of EU, Japan, Russia, Korea, and etc, you will suddenly find that the US represents a "rock-solid" financial powerhouse. That also tells you how indebted the whole world has really become.

A falling stock market and more bad news can help Obama's cause: it creates panic and forces more people to flee into US Dollar and Treasuries. US Dollar has now become gold's sidekick (or rather the other around), and these are now moving in locksteps over the past few months.

Feb 17 01:18 PM

[Aristophanes:]

There can only be one response to this, a lyrical response.

From Stevie Wonder's "Yester-me, Yester-you, Yesterday":

What happened to the world we knew
When we would dream and scheme
And while the time away
Yesterme yesteryou yesterday

Where did it go that yester glow
When we could feel
The wheel of life turn our way
Yesterme yesteryou yesterday

I had a dream so did you
Life
Was warm and love was true
Two kids who followed all the rules
Yester falls and now
Now it seems those yester dreams
Were just a cruel
And foolish game we used to play
Yesterme yesteryou yesterday

When I recall what we had
I feel lost I feel sad with nothing but
The memory of yester love and now
Now it seems those yester dreams
Were just a cruel
And foolish game we had to play
Yesterme yesteryou yesterday

Yesterme yesteryou yesterday
Sing with me
Yesterme yesteryou yesterday
One more time.....

Feb 17 01:25 PM

[doubleguns:]

Every country and bank and invester that thought they had a lot of money saw it evaporate in the great deleveraging of 2008. Much more is to come I believe. Money is vanishing faster than it can be made. It will have to get made or printed to keep up so I believe it will be printed. Monitization is the final card that will get played and when it does we are close to the end game for fiat money unless something miraculous happens.

Feb 17 01:25 PM

[Lockstep In...:]

Many of the comments to the article restate that our debt numbers are recordbreaking and that money will flee for one thing or another.

What I am talking about is reiterated by mkreisel, this is about relative strength of the US economy. When Japan is declining at a 13% annualized rate, there is no need to worry about global inflation. Look at the Moody's report today discussing how the Eastern Europe foreign denominated debt will bring about major defaults for Eastern European countries and major Western European banks. China does not have reliable statistics to report the forward situation, but I am sure we will see symptoms of the problems festering there soon. But they still need to invest their account surplus. Seeing this, is the US really so bad off? No. Many nations need to invest their account surplus and there has been marked decrease in the securities marked "AAA" in the world. (Is that the understatement of the year right there?). That is why a 100% increase in US debt issued per year is not a crisis inducing phenomenon in the short term.

I appreciate all the comments and feedback.

Feb 17 01:31 PM

[Simon Smelt:]

If there was a clearly better choice than the U.S. $ it would all be over already. Clearly the big boys, such as China, are trying to diversify away. With the massive bond issues by the U.S. and everybody else, there will be lots more opportunity to diversify. And the sheer volumes will make it difficult for the Fed to manipulate the markets in bonds or $ as it has.
Don't rely on the U.S. remaining the least worst currency.

Feb 17 01:34 PM

[Aristophanes:]

ONs of the sad things about this debt rebalancing is that the US, UK and Ireland encouraged consumer debt, whereas the banks in Western Europe were investing in increasing the productivity of its closest trade neighbours and allies in Eastern Europe.

The latter is undoubtedly more ethical in purpose if not execution than the former, and may still pay out in the very long run. If the Anglo-US gang revert back to import-based over-consumption, then the Fed will have perpetual issues. Europe has shown an incredible willingness to plow through major obstacles in governance and economics. The massive costs of East German re-integration, for example. Let's give credit (literally) where credit is due and not gloat.

Feb 17 02:04 PM

[bull_dog:]

More TLT goes up (yield goes down), the more it is a no brainer to short it. This is free money (almost) that you are borrowing. if you could think of any better investment of this money, you should do it. i can think of several such investments: GLD, SLV, GLX, FCX, NEM, tax free muni bonds, corporate bonds etc.

Feb 17 06:30 PM

[sabre_jenn:]

This article makes a number of dubious assumptions. Treasury debt is not an all or nothing proposition. You explore only two scenarios -- the Treasury keeps paying interest or it doesn't (some sort of default).

In the real world, investors buy bonds as a store of value. The relevant question is: if I buy $1000 in bonds today and hold them to maturity, will I still have the same purchasing power? What if I reinvest all coupons?

Healthcare costs are increasing 9-10% annually. State and local government spending (aka property taxes) are increasing 7-8% per year. Electricity rates are up 4-5% annually. Food prices are also up 4-5% annually.

You cannot keep up with prices (cost of living) rising 6-7% per year (averaging the above) by investing in a bond that yields only 3.5%. Claiming deflation on the assumption that your home price is falling, even if this is "deflation" (which it is not), will not pay the bills

To claim that an asset that loses 3.5% per year is somehow "risk free" is the sort of nonsense we have all come to expect out of Wall Street analysts. Get a clue guys

The only people buying Treasuries now are central banks and sovereign wealth funds -- buyers who are at least as interested in foreign exchange manipulation as cashflows. These folks need to invest tens of billions and "need" the liquidity of the Treasury market

If you aren't interested in manipulating foreign exchange rates, you care about cashflows -- which in the case of US Treasuries are absolutely 100% insufficient to cover your cost of living, never mind provide a reasonable rate of return

If you are investing a few million, or (ahem) a more modest amount like the readers of this website -- you have plenty of alternatives to US Treasuries.

Or you can keep losing 3.5% year after year after year -- compounding works against you just as powerfully as it works for you

Yeah, I know -- every reader thinks he/she will be smart enough to bail out at just the right moment. A lot of home speculators thought the same thing

Feb 17 08:30 PM

[Steve Hamlin:]

I would be interested to see a breakdown on Treasury market participants and their drivers.

The author's macro perspective is one correct view - that continued global financial problems and the somewhat-surprising continued U.S. strength (dollar,Tr) will cause continued global demand for safe-haven Treasuries, for which the U.S. Govt can pay virtually nothing. Result - prices remain high, yields remain low. That might occur over the next years - shorting TLT is a probably better than TBT for that. I certainly agree that the macro causes are interesting - Setser and Michael Pettis have more to say on that.

Another perspective is trading - in the panic, investors dumped any risk and gave the money to the U.S. Govt to safeguard (at point, for a 0.00% return). Look at a 1-year chart of the 30-yr. Look what happened in mid-Nov, the second leg down: everybody thought the world was ending, dumped equities in a de-leveraging fire sale, and jumped into Treasuries. Yields dropped almost 1800 bps in 35 days.

Over time, assuming things don't continue to get worse and deflation doesn't stick (a big if), the sense of panic and uncertainty will lessen, and those investors will want to start getting a decent real return. They'll rotate money out of Treasuries, back into riskier assets, starting at the top of the capital structure. Bonds, preferreds, equities.

In my mind, that is what TBT is for. It is a trade on when money will flow out of Treasuries and into something more risky.

That already started happening in later December - money moved out of Treasuries (yield up 1100 bps in 40 days) into munis, corporate bonds, high-yields, as those spreads compressed. Equities rallied from the November lows thru early January. Everyone was talking about appetite for risk returning.

So TBT has 45% since mid-Decmeber. Then things got dicey again recently, scared money retreated to the safety of Treasuries and Gold, selling equities and bonds. TBT dropped.

And if Obama ever comes out with something that doesn't suck, TBT will rally. And then Eastern Europe and East Asia start the global depression, and TBT will tank. And so on, and so forth.

I think of TBT as inverse of "how scared are people?" - pretty scared in Oct-Nov, a bit of relief in Nov-Jan, and now getting scared again (upon realizing the size of the monster and breadth of devastation for the first time).

Feb 17 08:54 PM

[Steve Hamlin:]

whoops - off by a decimal. 30yr Treasury yield dropped 180 bps in Nov-Dec, and gained 110 bps in January. "V" that benefited TBT nicely.


On Feb 17 08:54 PM Steve Hamlin wrote:

> I would be interested to see a breakdown on Treasury market participants
> and their drivers.
>
> The author's macro perspective is one correct view - that continued
> global financial problems and the somewhat-surprising continued U.S.
> strength (dollar,Tr) will cause continued global demand for safe-haven
> Treasuries, for which the U.S. Govt can pay virtually nothing. Result
> - prices remain high, yields remain low. That might occur over the
> next years - shorting TLT is a probably better than TBT for that.
> I certainly agree that the macro causes are interesting - Setser
> and Michael Pettis have more to say on that.
>
> Another perspective is trading - in the panic, investors dumped any
> risk and gave the money to the U.S. Govt to safeguard (at point,
> for a 0.00% return). Look at a 1-year chart of the 30-yr. Look
> what happened in mid-Nov, the second leg down: everybody thought
> the world was ending, dumped equities in a de-leveraging fire sale,
> and jumped into Treasuries. Yields dropped almost 1800 bps in 35
> days.
>
> Over time, assuming things don't continue to get worse and deflation
> doesn't stick (a big if), the sense of panic and uncertainty will
> lessen, and those investors will want to start getting a decent real
> return. They'll rotate money out of Treasuries, back into riskier
> assets, starting at the top of the capital structure. Bonds, preferreds,
> equities.
>
> In my mind, that is what TBT is for. It is a trade on when money
> will flow out of Treasuries and into something more risky.
>
> That already started happening in later December - money moved out
> of Treasuries (yield up 1100 bps in 40 days) into munis, corporate
> bonds, high-yields, as those spreads compressed. Equities rallied
> from the November lows thru early January. Everyone was talking
> about appetite for risk returning.
>
> So TBT has rallied 45% since mid-Decmeber. Then things got dicey again recently,
> scared money retreated to the safety of Treasuries and Gold, selling
> equities and bonds. TBT dropped.
>
> And if Obama ever comes out with something that doesn't suck, TBT
> will rally. And then Eastern Europe and East Asia start the global
> depression, and TBT will tank. And so on, and so forth.
>
> I think of TBT as inverse of "how scared are people?" - pretty scared
> in Oct-Nov, a bit of relief in Nov-Jan, and now getting scared again
> (upon realizing the size of the monster and breadth of devastation
> for the first time).

Feb 17 09:02 PM

[wmh:]

Treasury bonds are one of the few perceived safe havens having the ability to absorb the cash from those leaving equities, euro, etc. Gold is a safe haven too, but the gold market can only absorb so much without going to the moon. The more the world markets/currencies crash the more appealing treasuries and gold become. This trend has to end, and when it does, there will be an exodus from treasuries, and gold will...?

Feb 17 11:51 PM

[Aristophanes:]

On Feb 17 11:51 PM wmh wrote:

> Gold is a safe haven too, but the gold market can only absorb so
> much without going to the moon.

Ain't that the point? Gold = timing. Enjoy the ride ;-)

Feb 18 01:00 AM

[Mark Anthony:]

The basic notion of this article is so absurd it is a parlody! You are saying there is simply no good investment so US treasury bond becomes the best investment choice? There are plenty of valuable investment opportunities selling at greatly depressed price.

Mean while the US treasury bond market has become the BIGGEST DEATH TRAP in the market place:

seekingalpha.com/artic...

Let's put it this way, what do you expect in return when you buy treasury bonds? You expect the US government hopefully will pay you back more than you spent, not in nominal US dollar term, but in REAL PURCHASE POWER term. Is it possible? Our national debt, $10.8T, is now equivalent to 344,500 tons of gold. Can the US government ever pay back such a huge debt?

If the US Government can not pay you. Then the ONLY return you can ever expect to get from your US T Bond, is that another investor buys your T Bonds and hence pays you.

This, my friend, is a PONZI SCHEME. The US T Bonds has become the world's biggest PONZI SCHEME, because our government, just like Madoff, simply can not pay every one back.

Feb 18 03:56 AM

[Think-About-It:]

I can understand not shorting thresuries today but for technical and short-term reasons only. At some point the treasury bubble will be ready to pop and when it does it will be a great opportunity for shorting.

Let the Gov try to lower long-term rates over the comming months and let the deleveraging play out a little longer, then start building your position in TBT.

The author sates the following which I dissagree with:

"The Chicken Littles love to tell stories about how the Chinese are crazy for buying 30 Year Treasury Bonds at 3.5% and will soon take their money home for domestic investment for higher returns. This logic is flawed for two reasons. 1) A purchase of Treasuries increases in return if a government believes that its currency could possibly devalue versus the USD in some point in the future. In such case, the USD denominated Treasuries provide a highest quality hedge against any internal stability risk and also against lagging relative performance for China versus the US economy. 2) Besides the Fed Discount rates, the Fed also has the ability to control rates by choosing where on the yield curve it issues debt..."

It is the USD that will weaken moreso than the Renminbi which will provide further motivation for China and other countries to divest away from US treasuries.

Feb 18 09:57 AM

[kelm:]

Your article attributes concerns about foreigners moving from buying US debt to some other investment vehicles as "chicken little". You need to do a little research.

Example
1) Feb 11th, former adviser to the Chinese Central Bank stated that China should ask for guarantees on US debt China holds

2) Feb 12th Bloomberg - senior Chinese regulator "clarifying" his previous statements FROM: China had no real choice but to buy our bonds, TO China has many options including gold and other currencies.

3) Feb 19th Bloomberg article quoting European Central bank Board member on the growing risk of a loss of confidence in states that are issuing too much debt

4) Financial Times Feb 17th quoting Middle Eastern sources regarding rising concern with US debt position as well as need to focus their capital on their own economies

5) Any of the recent stories on China's purchases of key stakes in global commodity producers. They are diverting foreign exchange reserves into foreign hard asset purchases around the globe to ensure commodity supply in the future.

6) China abruptly stated mid-week last week that none of their banks would participate in the AIG asset auction. The day before the market was waiting for the announcement of which bank it would be.

Taken together there is a rising concern amongst powerful interests that The US has relied on to finance ourselves that our fiscal position and direction are not sustainable. China in particular seems to be sending a message. I've talked about this on my site in greater detail.

Feb 18 11:15 AM

[popey:]

Sorry you have got to be joking. 40% GDP "recurrent" expenditure is a disaster. This raises national debt to over 100% of GDP, and net-present value obligations of 50 trillion bring "calculable" obliagtions to about 500% of GDP.

I do agree that timing is an issue (maybe wait for quant easing). But the bond market will collapse under these pressures, and will usher in a national catastrophe and social unrest not seen in the USA ever.

What a disaster. Move to New Zealand.

Feb 18 12:58 PM

[Carneades:]

We find common ground on your assertion that sovereign nations have few options "regarding where to put major currency". Unfortunately, this entire piece seems to be built upon the premise that at least some nations will in fact generate a surplus. The combined crash in oil/commodity prices and entrenchment of the American consumer will continue to decimate the economies of virtually every nation upon the globe. In addition, we fail to see how the Great Bernanke will go to battle with the market and emerge victorious. This after numerous and repeated failures throughout every stage of this financial crisis.

Feb 18 09:06 PM

[UKInvestor:]

Hi



I would like some help on TBT. I am based in the UK and pretty bearish on USD and GBP, however I do think GBP will appreciate against USD this year. One particular trade I am interesting is shorting the UST bubble and like the leverage of TBT. The question I have is that to buy TBT, I have to fund in Sterling, therefore if GBP appreciates in the next year this will cause a loss on my TBT position. I could of course swap the FX risk out via a spreadbet or similar, but before I do this I wanted to see what other views / alternatives are available.


Many thanks in advance.

Mar 18 12:08 PM