Shorting Treasuries with Inverse ETFs

Today is a day to give thanks.

I know it’s a little early for Thanksgiving, but I’m talking about being thankful to Uncle Sam and the U.S. government for the bountiful opportunity they have given us to make huge loads of money in a relatively short amount of time.

I’m talking about shorting U.S. debt via 2 specific, but very risky vehicles:

• Ultrashort Lehman 20+Year Treasury Proshares (NYSE: TBT)
• Direxion Daily 30 Year Treasury Bear 3X Shares (NYSE: TMV)

Thank You Mr. President

Since the collapse of the yield curve late last year when people were panicked in the market such that they were willing to take NEGATIVE returns on their money via U.S. Treasuries to ensure some type of safety, things are starting to normalize now, and in fact swing the other way.

This has given us one of the biggest opportunities in the last 50 years to take advantage of a punch drunk bumbling and stumbling government spending itself into possible oblivion.

A little harsh you say?

Perhaps, and I’m not one to judge, but I am certain of one thing: As Warren Buffett recently stated, the bubble in U.S. Treasuries is one of the largest of all time, even bigger than the housing bubble that we just witnessed collapse.

In fact, Buffett highlighted the sale in late 2008 by Berkshire Hathaway of a Treasury bill for a negative yield.

Buffett wrote in Berkshire’s annual letter in February that when “the financial history of this decade is written…the Treasury-bond bubble of late 2008″ may rank up there with the housing bubble of the early to middle part of the decade.

What The Heck Are You Talking About?

For those that are uninitiated, I’ll break it down in simple terms:

The U.S. government is printing money.

They are doing this to help stave off an apparent collapse in the banking sector, add liquidity to the market, AND prop up the U.S. economy with various stimulus packages.

How do you come up with money that you don’t have?

You borrow.

So how does the U.S. government borrow?

They issue Treasuries dated in different maturities ranging from 1-30 years.

Who buys this debt?

All sorts of folks from around the world, but mostly our neighbors to the East, China, Japan, and other countries.

What terms does the government have to offer them to take on ever increasing amounts of our debt?

Well, not too long ago, those terms were rather modest, and were akin to basically borrowing money for free, with yields going down below 3% for the 30 year notes in late 2008, and far lower yields for shorter maturities, it was a no brainer to take on more debt when being able to pay it back at such favorable terms.

That however, is now changing with Treasuries declining about 20% from those highs, and the yield now over 4% and climbing fast.

What happens when lenders, or buyers, don’t want any more debt?

We have to increase the payout they get for taking on more debt, thus lowering Treasury prices, and increasing the yield, since they work inverse of each other.

OK, I Get It, So What’s The Big Deal?

There are several reasons why it’s time to buy either of the 2 ETF’s that I am recommending now: the Ultrashort Lehman 20+Year Treasury Proshares (NYSE: TBT), or the Direxion Daily 30 Year Treasury Bear 3X Shares (NYSE: TMV).

Here’s some of those reasons in no particular order:

• Yields are still low by historical measures, meaning we have a long way to go before we are “tapped out”. With room to run, the government isn’t nearly finished yet applying for and getting more money from outside sources or printing their own.
• The threat of DEFLATION has lessened or disappeared entirely, and now folks are concerned with INFLATION again with rising prices for energy, commodities, and other items, despite the global recession.

This is bad news for our money, as it becomes less valuable, and you guessed it, in order to garner more buyers for our debt, we have to increase the yield being paid out, lowering Treasury prices further.

While holders of Treasuries ultimately will get their money back, prices could fall sharply in the interim, and repayment could be in greatly depreciated dollars.

• The massive federal stimulus program ultimately may lead to much higher inflation. Again, higher prices because we are artificially increasing the money supply, and making our currency worth less.
• The government’s efforts to prop up the yield are proving unsuccessful. The U.S. government has been trying its hardest to prop up Treasury prices and the yield by buying them up, but it is no longer working, as prices continue to fall, and yields continue to increase despite their best efforts.

Look for this to not only continue but worsen as the slippery slope of higher yields leads debt buyers to demand even higher rates of return for taking on higher amounts of risk

• There is some scuttlebutt out there that the U.S.’s credit rating is under review and might be downgraded from its sterling AAA rating. If this happened, it would send imminent shockwaves through the Treasury market, as U.S. debt would all of a sudden become riskier, and yep, cause investors buying our debt to demand even higher yields, pushing down Treasury prices further.
• Recent offerings showing weakened demand. The U.S. has had a busy week of auctioning Treasuries this week and demand has not been that great, with a huge decline in Treasury prices Wednesday, and I expect much more Thursday and in the coming weeks and months as the government floods the market with Treasuries that borrowers simply cannot absorb, don’t want, or will demand significantly higher terms to take on.
• The U.S. dollar is losing value quickly. In order to prop up our currency, the U.S. government will have to raise interest rates inevitably because it will make our currency stronger, so yep, it means that Treasury prices will decline and yields spike.

On the flip side, if the U.S. dollar declines in value further, and the government doesn’t raise interest rates, well guess what? Treasuries STILL fall in value along with the declining dollar.

It’s almost a no lose situation for an investment SHORTING Treasuries, and thus my recommendation for buying one of the two vehicles mentioned: the Ultrashort Lehman 20+Year Treasury Proshares (NYSE: TBT), or the Direxion Daily 30 Year Treasury Bear 3X Shares (NYSE: TMV).

OK, So Now What?

Well, now its time to either familiarize yourself further with these ETF’s and do some more homework, or understand what is happening on a macro level so that you know where you are putting your money.

To that end, I highly recommend reading the aforementioned ETF’s prospectus’, or K’s, and doing some further reading on the subject.

One author that I highly respect that has written extensively on this subject in far more detail and knowledge than I possess is Paco Ahlgren.

You can read his latest post on where to put your money here.

You can also read my last post on ETF’s to get comfortable with what they are and how they work here.

Let’s Go Shopping

In the coming days/weeks, I’ll be entering these positions, most likely the TMV because it provides 3 times the inverse of Treasury prices, rather than the TBT, but both are on my radar.

I feel that this opportunity is simply too juicy to pass up, regardless of the short term risk.

Treasuries WILL fall in price, yields will rise, and we will make out like bandits.

If you are interested in following my real time trade advice, please be sure and subscribe to my Twitter feed.

A Word of Caution

I will warn you that these ETF’s are not for the faint of heart, timid, or for money that you cannot afford to lose.

These ETF’s work on an inverse principle so that if Treasury prices go up, they go down, and vice versa.

But they don’t just go down on a 1-1 basis, they go down 2x their tracking index in the case of the Ultrashort Lehman 20+Year Treasury Proshares (NYSE: TBT), and 3x for the Direxion Daily 30 Year Treasury Bear 3X Shares (NYSE: TMV).

With this leverage, it is possible to make 100% return with just a 50% move in Treasury prices to the downside utilizing the TBT, and 150% for the TMV, however since these ETF’s rebalance and recalculate daily there is a compounding effect that takes place that can be both beneficial and very detrimental, which is why they are only meant for short term plays, or if you are like me, a risk on long term movement you are willing to stick with for the absolute riskiest portion of your portfolio.

This can absolutely kill you in a bearish scenario because say Treasuries increase in price by 10% in one day, the TMV will DECLINE by 30% in one day!

A theoretical investment of $100, would be worth $70, while on a 1-1 basis, you would have only lost $10.

So you can see how you can greatly underperform EVEN IF the price spikes the next day and so on, because you have to make up for the difference of the fall you took.

Of course, on the upside this works in your favor, as a comparable loss is mitigated by the gains you have made over time.

Unlike the other investments that I talk about and recommend on my site, these don’t have any “fundamentals” or management to vet, balance sheets to look at, or other similar things that we can use to gauge risk, and give us an edge over Wall Street, aside from the macro factors discussed above.

If you decide to play any of the ETF’s that I am writing about today, you do so at your own peril.

Remember that ETF’s represent a basket of securities, commodities, bonds, etc., and are usually never tied to any one company, or product, aside from ones like the TBT and the TMV, that specifically play on one theme.

As such, these funds move at the whims of the market, and can turn on a dime in either direction.

They are emotional and momentum based vehicles useful for playing panic or overeaction in either direction, like we had with negative yields on Treasuries.

Be wise, use tight stops, and tread lightly if you cannot afford to lose that money.

Bottom Line

ETF’s are a wonderful way to play larger themes, or get into investments that you otherwise would have no business investing in, or would not have the means in which to invest in as an individual investor with limited resources.

Used carefully in conjunction with a balanced portfolio, ETF’s offer a great way to play on some of the themes playing out before our eyes, where we know that we can make money, we just might not know how.

Be on the lookout for more information from me very soon as I will look to enter either the Ultrashort Lehman 20+Year Treasury Proshares (NYSE: TBT), or the Direxion Daily 30 Year Treasury Bear 3X Shares (NYSE: TMV).

If you are interested in following my real time trade advice, please be sure and subscribe to my Twitter feed.

Want More?

• Read Paco Ahlgren’s latest post on where to put your money here.
• You can also read my last post on ETF’s to get comfortable with what they are and how they work here.

Comments

[Mad Hedge F...:]

You are right on track. One of my core positions, the PowerShares Lehman 20 Year 200% short ETF (TBT), a bet that benefits from falling long Treasury prices, hit a new high for the year today at $57. Long time readers of this column got into it in December at $35. The ripple effects of last week’s US downgrade chatter is still feeding into prices, exacerbated by another huge slug of new issuance this week. Treasury futures got slammed, gapping down two points to 118 3/4, and are off a breathtaking 20% from the recent peak. I think the downgrade talk is premature, and the inflation rationale for this trade is still years off. The news about another North Korean nuclear test is just noise. But when a security is as accident prone as Treasury bonds, you never know which of the panoply of negative surprises is going to hit first. I think the bond bubble has popped, and that the TBT could eventually spike to $200.

May 28 09:00 AM

[Baboon:]

I wish there was ETF product that would allow to trade the interest rate itself ( including short term interest rates ) not the price of bonds. That would help investors avoid paying interest on the short bonds positions.

May 28 10:03 AM

[harianivi:]

you say that you will be looking for to enter tbt or tmv, i was wondering if you will clarify as to what you are looking for.

May 28 03:59 PM

[Alan Young:]

Chris, you're entirely right about the fundamentals of this trade. Treasuries (as in TLT) will go down, inevitably.

But I'm surprised that you are so simplistic as to believe that being right about the fundamentals means that it's "almost a no lose situation." There are still plenty of ways to lose, due to the behavior of the leveraged funds.

Remember, whenever the price goes down, the Fed can buy and drive it up again. Yes, the effect may be short-lived, and there's a limit to how long this can go on, but by the time they reach that limit, the up-and-down resetting of your leverage can make a mess of your trade.

This behavior can be observed with a hypothetical short of XLF, using FAZ. At the close on May 6, with XLF at 12.48, you buy FAZ at 5.24. Today (5/28) at the open, you cover, with XLF at 11.77. You have correctly timed your short, as the index fund has gone down 5.69%. You should have a 17% profit, right?
But in fact, FAZ closed at 4.96, today. You have lost 5%!

So, with a leveraged inverse fund, you have to have not just the right fundamentals, but the right timing. Even a short-term trend reversal will kill you.

And the other bad news is, you're probably too late. TLT has already fallen to its long-term support line, and bounced (dead-cat style, on two successive days). Technically, it's very unlikely to keep falling in any kind of hurry.

I am holding a small amount of TBT as a short-term trade, but I will keep it tightly stopped. The odds for it are not that great.

May 28 04:52 PM

[radicall:]

I agree with Alan Young. I like these instruments when a big move seems likely, like the next time the Fed is ready to issue new debt.

As far as the author - I think the author did a good job of explaining who buys the treasuries, but just for the noveice I couldn't find a good article that explained

a) What are treasuries
b) Why does the government issue them
c) You explained who buys them
d) When Treasury notes are "guaranteed money", how can they lose value (interest rates go up, new notes available with higher yield for similar maturity so nobody will buy a lower yielding asset for the same price, hence the price goes down)
e) Just a little blurb about the future value of money
f) Effect of the stock market returns on yield expectations
g) Yield Curve
h) Mortgage rates
i) Why and how Mortgage Bond buyers Hedge against future rate increases
j) What happens to Mortgage rates and economic recovery when yields increase
k) What happens to the Stock market and the economy when rates increase before the economy recovers.
l) What happens to yields if Stock market / economy nosedives

May 28 10:10 PM

[Chris Ferna...:]

Hey guys,

I am not a timing or chartist expert, so my article was not designed to time the move or pretend that there was no risk.

However, for the reasons that I outlined, I believe that although the vehicle for playing this might be volatile, and yes, the compounding and volatility issues might erode your return, I still think that we are headed for something major here in the next few months, and I want to be ahead of that.

True that the spike in interest rates a few days back was too much too fast, thus why I am waiting for a pull back, but the mega trend is in place, and I think we'll reap the benefits soon enough.

Chris

May 29 02:51 AM

[Baboon:]

Could somebody please explain to me: even if the rates will move higher and investor sells bond etfs to benefit from falling prices shouldn't he overcome the total return to be profitable since he has to pay interest to the bond holders? Another problem: short-term interest rates are more volatile than the long-term interest rates but the short term etfs ( BIL for example) barely move.

May 29 08:06 AM

[radicall:]

That is a good point Baboon, when you short treasury bills that are yielding 3% you do have to pay out 3% interest. The interest is implied rather than actually paid since STRIPs are sold at a discount, so as long as the yields do not change - you are losing 3% a year at least. In case of 2x leveraged Ultrashorts you should be losing 6% per year without adding any volatility decay or management fees of the ETF.

Lets hold it for 3 years with no major movement in yields (big assumption but possible scenario if the recession gets worse, which it will if mortgage rates go up, energy costs go up but the economy still stinks) so we already lost 18% being short.

Now let's say at this point, 2 year interest rates become 5%. The bond would fall in value by roughly 4% so the 2x inverse would rise 8%. 18% loss - 8% gain=Total loss of 10%.

These people (green shooters) think economy is going to be booming again in 6 months and that we are in a secular bull market (stocks). T

here is of course the other party - the America haters who think that the world will not buy US treasuries with such low yields - well the auctions went well. Also just wait for the stock market to drop 15% in a month (which should happen at least once in the next 6 months) and people will want to protect their principal by buying treasuries again at negative yields.

I just want to start an ETF that feeds of the volatility decay of other leveraged ETFs. You short the long and short leveraged ETFs and rebalance daily. Guaranteed profit (not accounting for major tracking errors)!

position: short TBT through puts

May 29 09:57 PM

[Chris Ferna...:]

Radicall,

Awesome points!

I have not officially started my position yet in TBT or TMV, and don't intend to yet either till I see some stabilization in the bonds, or other compelling reasons.

Today's drop in price puts the TBT technically right around resistance/support, so it could be a nice entry position either way, but I like your play of shorting TBT, or going long TBT, regardless and making money both ways.

Although I think the longer term trend is for yields to move sharply higher, I didn't mean to suggest I would be utterly opposed to shorting and going against my own trade for a short term profit boost.

Chris

May 30 01:52 AM

[dizzyfingers:]

Too confusing and dangerous for most of us. But interesting.

Jun 08 10:02 AM