Treasuries, Mother of All Bubbles, Is Primed to Pop

US Government debt is in big trouble.

For years, the US has been funding its deficits by issuing debt in the form of Treasuries: US Government-backed bonds. Because of the US’s standing as a world superpower, these investments were considered to be “risk-free”- by buying them, you were essentially betting on the US maintaining its good standing.

However, once the Federal Reserve started allowing investment banks and other financial entities to swap their toxic mortgage-backed securities and other financial garbage for Treasuries, the US started broadcasting a message to the world:

WE DON’T VALUE OUR CURRENCY OR BONDS.

This is already having serious consequences on the rest of the world. China and Japan (the two largest holders of US debt) have begun expressing serious concerns about what the Feds are doing. In fact, China’s premiere has begun hinting that should the US continue down this route, they will not continue to fund out debt:

Whether we will buy more U.S. Treasury bonds, and if so by how much -- we should take that decision in accordance with China's own need and also our aim to keep the security of our foreign reserves and the value of them.

And if that comment isn’t clear enough, consider the following statement he made at the beginning of May:

We have lent a huge amount of money to the US…Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried.

These statements and others like them resulted in Secretary of State Hillary Clinton flying to Asia to plead with China and other US creditor nations to continue buying US Treasuries. “By continuing to support American Treasury instruments the Chinese are recognizing our interconnection. We are truly going to rise or fall together," Clinton said at the US embassy there.

Make no mistake… if China chooses to stop buying Treasuries, the dollar is DONE.

In fact, it may already be happening. According to the New York Times, China’s foreign reserves grew in the first quarter of 2009 at the slowest pace in nearly eight years, edging up $7.7 billion, compared with a record increase of $153.9 billion in the same quarter in 2008.

The effect of this is already showing up in the bond market.

click to enlarge

As you can see, US 30-Year Notes have begun a steep slide in the last five months. Part of this is China. The other part is investors growing less fearful due to a strong rally in stocks. Depending on how the financial crisis continues to play out, (whether or not China chooses to continue slowing its purchases of our debt) we could see a virtual free fall in the US dollar.

And when we do, you can profit with the UltraShort Lehman 20+ Year Treasury ProShares (TBT).

For starters, do not let the name alarm you, this ETF has NOTHING to do with Lehman Brothers. It simply returns 2X the return of a longer-term bond index Lehman Brothers organized long before going under. Again, it has NOTHING to do with Lehman Brothers.

TBT is an inverse fund, meaning its returns the inverse of another index (in this case a long-term bond index organized by Lehman Brothers before it went under). Usually inverse funds return 1X the inverse. Meaning if the underlying index falls 5%, the inverse fund rises 5%.

However, in the case of TBT, it’s a double inverse fund, meaning it returns twice the inverse of its underlying bond index. So if long-term bonds fall 5%, TBT returns 10%. If long-term bonds fall 20%, TBT returns 40%. You get the general idea.

Simply put, TBT is a well-diversified means of playing the eventual bear market in longer-term bonds. You get broad exposure to a major trend, without the risk of putting all your money in any single bond short.

Looking at the above chart again, you can see that the US-30 Year Treasury has shown strong support at 113 over the last year. As I wrote this, it was trading around 122, largely due to the enormous spike that occurred during the financial collapse in October-November: at that time, investors piled into Treasuries as a safe haven.

Indeed, this buying binge is what has led to a bubble in Treasuries. Warren Buffett recently warned investors,

When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s… But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.

So whenever the 30-Year Treasury finally breaks below 113, the Treasury bubble will have burst. It will be then be time to buy TBT.

Comments

[Whitslack:]

No mention of the leverage-induced tracking error of TBT (and all leveraged ETFs). Yes, it is true, if Treasuries head straight down the toilet, TBT will do quite well, but if they waffle around a while, the volatility will eat TBT for breakfast. You're actually better off shorting both TBT and TLT in equal amounts and pocketing the compounding error.

May 20 08:12 AM

[Bulldog12:]

Whitslack, the strategy you are referencing will not work because TLT and TBT will have slippage in the SAME direction not opposite directions. Look at a one year chart comparing both and you can see it clearly.


On May 20 08:12 AM Whitslack wrote:

> No mention of the leverage-induced tracking error of TBT (and all
> leveraged ETFs). Yes, it is true, if Treasuries head straight down
> the toilet, TBT will do quite well, but if they waffle around a while,
> the volatility will eat TBT for breakfast. You're actually better
> off shorting both TBT and TLT in equal amounts and pocketing the
> compounding error.

May 20 11:28 AM

[atlasman:]

"When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s… But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary"

The great one is incorrect on this one. The Treasury bust will eclipse the others.
-AM

May 20 01:51 PM

[mlyn:]

If China and others do not buy our treasuries and the Fed steps in and buys them, then doesn't it continue the bubble?

May 20 07:51 PM

[tedfoo:]

Yes this is exactly what will happen, the fed will step in and buy it, or at least provide a floor. They can just print more dollars if they need to.

For an investment idea, I'd stay away from the TBT due to leveraged ETF decay. The small time investor doesn't have the ability to truely short treasuries and the ETF isn't an efficient way to do it (unless your timing is awesome).

Either way, the author is right, and this bubble is poised to pop. The end result of all this as I see it is a debasing of the dollar. I just think you'll get more bang for your buck by playing inflation bets or shorting the dollar.


On May 20 07:51 PM mlyn wrote:

> If China and others do not buy our treasuries and the Fed steps in
> and buys them, then doesn't it continue the bubble?

May 20 10:08 PM

[JPPennypacker:]

I think somebody with awesome timing could do very well on leveraged ETF's such as TBT. It seems to be a great investment vehicle for the lucky and those with impeccable timing, but almost anything can be a great investment if well timed.


On May 20 10:08 PM tedfoo wrote:

> Yes this is exactly what will happen, the fed will step in and buy
> it, or at least provide a floor. They can just print more dollars
> if they need to.
>
> For an investment idea, I'd stay away from the TBT due to leveraged
> ETF decay. The small time investor doesn't have the ability to truely
> short treasuries and the ETF isn't an efficient way to do it (unless
> your timing is awesome).
>
> Either way, the author is right, and this bubble is poised to pop.
> The end result of all this as I see it is a debasing of the dollar.
> I just think you'll get more bang for your buck by playing inflation
> bets or shorting the dollar.

May 21 12:45 AM

[Gregman2:]

This is also why China is now buying commodities.

May 21 01:10 PM

[socialismSUCKS:]

The Fed is already buying and look what's happened since the announcement. The 10 year yield dropped to about 2.5 and is now close to 3.5. That's a 100 bp move in a few months after the Fed's big announcement. So much for lowering yields.

When the Fed buys Treasuries, they have to print money to do so. The only thing printing money accomplishes is debasing the currency which will ultimately lead to higher interest rates. The St. Louis Fed recently put out a paper making this same argument - basically saying that Bernanke is crazy to think that buying Treasuries will lower yields.

The most powerful man in the government, the money creator, is totally insane.


On May 20 07:51 PM mlyn wrote:

> If China and others do not buy our treasuries and the Fed steps in
> and buys them, then doesn't it continue the bubble?

May 22 07:49 PM